11 Prospects for Increasing Foreign Direct Investment in Low-Income Countries
- Zubair Iqbal, and S. Kanbur
- Published Date:
- September 1997
The increase in the share of private flows and the decrease in the share of official flows to developing countries means a shift from a political universe of discourse to a voluntarist one—in Moises Nairn’s words, “from courting the state to courting the market.” This paradigm shift requires basic behavioral changes in the developing countries.
It is natural for government officials and aid providers to focus on the progress being made in individual countries. Governments have come to feel that they deserve to be “rewarded” for progress, and official aid providers are strongly motivated by such progress, where it has taken place. But private foreign investors (and, more and more, domestic investors as well) have a different perspective. To them (especially portfolio investors and the tens of millions of private savers, including the widows and orphans on whose behalf they invest), “the world is their oyster.” They are free to invest or not to invest in any of nearly 200 countries; what they are asking is, How does the risk/rewards equation in country X compare to the best in the world? They may well have only slight interest in the progress a country has achieved or in efforts that are being made by governments. To put it more bluntly, the key question of portfolio investors often is, Would you like us to invest your pension in country X?
Foreign direct investors whose assets are in the form of buildings, plants, machinery, and other facilities, none of which can be easily liquidated, tend to act on the premise that investment decisions represent a lasting commitment. But when investors come to believe that things really are going wrong in a particular country, they have shown that they are willing to divest even when it means a heavy short-term loss.
This paper deals mainly with foreign direct investment, but the dividing line between portfolio and direct investment should not be drawn too sharply, especially where foreign companies are buying existing assets in the course of privatization. Furthermore, portfolio and direct investment are often mutually supportive. Portfolio inflows can help to broaden and deepen capital markets, and this will also help future direct investors to secure local financing. Also, portfolio flows can lead to improvements in the regulatory framework, notably better disclosure, which increases comfort for foreign direct investors.1
Overall Picture Regarding Foreign Direct Investment
This said, and narrowing the focus down to foreign direct investment, what is the picture? The figures show trends in private investment and FDI, distinguishing three types of developing countries: small, low-income, large, low-income, and all others (Figures 1 and 2).2
Figure 1.Share of Private Investment in Developing Countries
Sources: Worid Bank and IMF data.
Figure 2.Foreign Direct Investment In Developing Countries
Sources: World Bank and IMF data.
Corporations invest abroad for any (or any combination) of the following reasons: (1) to exploit technology and managerial, financial, or marketing strengths to enter or expand into specific foreign markets; (2) to exploit natural resources, usually employing specialized and often techno logically sophisticated methods; (3) to exploit low-wage, but sufficiently skilled, labor to serve as a base for exporting to other countries; (4) more and more, to sell services, in which case a local presence is normally required. Low labor costs, by themselves, have declined in importance as an FDI magnet today, except in some activities (for example, garments and software development). One reason is that the share of labor costs in manufacturing has been declining over time. Another is that low-cost labor often also means low-productivity labor. Figure 3 is derived from a recent survey of 223 expatriate managers based in Asia published in The Economist (1996), which documents perceptions of labor attributes in various Asian economies and compares them to those in industrial countries. The survey considers factors such as quality, cost, availability, and turnover. Interestingly, while on cost alone India comes out way ahead, followed by the Philippines, Vietnam, and China, when all factors are taken into account, India remains ahead, followed by Australia and the United Kingdom, and labor attributes in Vietnam and China are considered by managers to be less attractive than in the United States and Switzerland, even though Switzerland, together with Japan, has the highest labor costs in the sample of 16 economies.
Figure 3.Index of Labor Cost and Quality
Sources: World Bank and IMF data.
Index: 0 = best; 10 = worst.
How crucial are the policies of developing-country governments in influencing foreign investment decisions? A famous Washington hostess of the 1950s used to tell young girls, “You either have to be pretty or I suggest you learn to speak French.” The same is true of host countries. “Being pretty” means being perceived by investors as having inherent attractions, such as a large and expanding market. Investors will overlook the most elementary requirements to be present in such countries. Examples include China (where company law is embryonic and judicial institutions untested by foreign investors), Mexico, and India (see Figure 4, which shows the ten top recipients of FDI).
Figure 4.Ten Top Recipients of Foreign Direct Investment, 1994
Source: IMF data.
But if you don’t happen to be “pretty,” that is, if your market is small and unlikely to expand very rapidly, and your country doesn’t possess inherent attractions, then the only way you can attract private capital may be by “learning to speak French,” that is, making yourself attractive. The average GDP, a proxy for market size, of sub-Saharan African countries, for example, is only about $5 billion, one-hundredth of China’s or Brazil’s markets, which themselves are not that large on the world scale, only about the size of Canada.
Even so, the surprising thing is that many small countries, including low-income ones, are receiving more FDI proportionately than are the larger developing countries. The usual focus is on dollar flows. These show that China, Mexico, Malaysia, and other relatively large economies are among the ten top recipients of FDI. But if, instead of looking at dollar amounts, one looks at what matters most from a developmental point of view, namely FDI per unit of GDP, then, for instance, in 1994 Vanuatu, Trinidad and Tobago, and Peru attracted more FDI than did China (Figure 5).
Figure 5.Ten Top Recipients of Foreign Direct Investment, 1994
Source: IMF data
Market size is only one factor, albeit a very important one. In my view, the more successful economies “speak reasonably fluent French,” meaning that the more fundamental development conditions are met: law and order, secure property rights, enforceable contracts, a functional financial system, and market-determined prices, including exchange and interest rates. Successful institutions are characterized by their efficiency and credibility. Incentives have to do with the whole gamut of risks and rewards. This is not the place to discuss these, except to say that abundant natural resources cannot substitute for institutions and incentives that are considered by investors to be far short of world class. The most successful economies (Japan; Republic of Korea; Hong Kong, China, and Singapore) have become prosperous largely because they never were tempted to rely primarily on natural resource exploitation for their development.
In most low-income developing countries, indeed, in most developing countries and certainly all the transition countries, what stares one in the face is the often staggering imbalance between government responsibilities and administrative capacity. Whether it is because of their colonial inheritance or for ideological reasons or both, as Sir Arthur Lewis noted more than 40 years ago, “The list of governmental functions is even wider in the less developed than in the more developed economies…. On the other hand, the governments of the less developed countries are at the same time less capable of taking on a wide range of functions than are the governments of the more developed. Their administrations tend to be more corrupt and less efficient, and a smaller part of the national income can be spared for government activity.… In fact, one cannot usefully consider in an abstract way what functions a government ought to exercise without taking into account the capabilities of the government in question. It is very easy to overload the governments of less developed economies, and it is quite clear that it is better for them to confine themselves to what they can manage than for them to take on an excessive range” (1955, p. 382). In the same vein, between 1978 and 1991, the most recent year for which fairly comprehensive data exist, state-owned enterprises (excluding financial institutions) accounted for almost 14 percent of GDP in low-income countries, compared with only 9 percent in middle-income developing countries.
This is not to say—far from it—that the state has no role to play. On the contrary, an efficient state is every bit as important to development as an efficient private sector. And just providing what the private sector cannot produce—for example, civil peace, law and order, respect for contracts, a sound regulatory framework, and health and education services for the poor, particularly the rural poor—is an incredibly demanding agenda that very few developing-country governments manage to the satisfaction of their citizens.
Implications for Investors
What are the main implications for foreign investors? The World Bank’s Foreign Investment Advisory Service has documented in a number of developing countries the steps that foreigners are required to take before they may invest. For example, Figure 6 shows requirements for a sub-Saharan country that is trying to attract additional foreign investment. In contrast, in Hong Kong it can take less than a day to obtain a business license.
Figure 6.Process for Foreign Manufacturing Firms to Establish Operations
This brings me to the subject of corruption. Corruption clearly is a highly undesirable phenomenon, yet it does not necessarily deter foreign investors, at least in the short run. Getting back to “being pretty” or “learning to speak French,” corruption seems much less of a deterrent to investment in large and expanding markets such as some of the East Asian “miracle” economies than in small ones. And, building on the growing literature on credible commitment, corruption damages investor confidence most the less credible the commitments of the bribees are; in some fast-growing developing countries corruption is commonplace, but is a fairly predictable cost of doing business, and bribers can be sure of what they are buying. In contrast, in the majority of developing countries, corruption itself has low credibility—bribers are not sure whom to bribe and, most important, whether or not they will get what they are seeking to obtain. This deters all investors, even those who have few scruples about bribery.
The fact of the matter is that where competition exists—and making sure that it does is one of the prime tasks of government—the scope for corruption is restricted. Corruption occurs at the interface of the private sector and the state. Every official who has the power to say “no” is a potential corruption point. Hence the smaller the size of the state, the fewer are opportunities for corruption. A recent study correlates corruption to the degree of economic freedom—a proxy for the extent of government regulations that affect investors and consumers. The findings are striking.
Across countries, there is, as you would expect, a clear negative relationship between the degree of economic freedom and the extent of corruption, as measured by Transparency International’s (TI) 1996 index (Figure 7). Indeed, the two lines form a pretty clear letter X (Chafuen and Guzman, 1996). Some people have argued that the private sector is at least as corrupt as are governments, and this is true in theory, but corruption within or among private sector firms is a cost, and the companies involved have a clear pecuniary interest in eliminating it where they can.
Figure 7.Economic Freedom and Corruption
Source: Chafuen and Guzman (1996).
To sum up, first, it is not true that small low-income countries cannot attract foreign direct investment; indeed, small countries generally have attracted more, not less, FDI, in relation to their economic size than have the larger developing countries. Singapore, which used to be a very poor and small country bereft of natural resources, managed to attract enormous amounts of foreign investment thanks to a single-minded effort to provide a world-class environment for foreign investors.
Second, for various historical and ideological reasons, in many of the poorer countries, the responsibilities of government are now more extensive than they are in the industrial countries, which have much greater administrative resources. In the case of foreign investors, this leads to the paradoxical situation whereby even if a government is trying hard to attract foreign investment, would-be investors often find themselves enmeshed in a seemingly inextricable web of bureaucratic red tape that adds to transaction costs and invites corruption. Public officials do not always realize that private investors are not aid agencies. Private businesses have no moral or political obligation to invest in this or that country; rather, they routinely consider all countries and weigh risk and reward, gauging country situations against the standards of world-class investment destinations.
What Can Governments Do?
So what can governments of low-in come economies do? Since other papers in this volume focus on the broader issues, I have left aside so far the paramount need to establish macroeconomic stability, restrain the fiscal deficit, maintain a realistic exchange rate, and perhaps most important, introduce competition, for example by opening up to foreign trade and investment, where it is lacking. I cannot emphasize the importance of opening up enough. Mauritius and Chile, for example, opened up their economies and thereby gradually removed the tremendous constraint of depending on a very limited domestic market. In competitive open economies, job creation and training respond to increasing effective demand for goods and services and not, as is the case in too many developing countries, to the expansion of the government sector—which is largely politically motivated rather than market driven and in the end is unsustainable.
First and foremost, governments can make themselves attractive to foreign investors by deregulation. A good first step is to compile between two covers all the red tape that a would-be foreign investor faces. As noted, FIAS and IFC have considerable experience in this area.
Second, privatization has been a major magnet for foreign direct investors. In the case of transition countries and of Latin America, a high proportion of FDI has consisted of purchases of formerly state-owned companies; typically this is followed by modernization and expansion, which the former state company was unable to finance. Interestingly, 50 percent of privatization FDI was in infrastructure, including telecommunications, electric power, ports, toll highways, and so on. Privatization has lagged behind in low-income countries; hence, considerable potential remains for attracting foreign investment.
Privatization is also important as an indication of a government’s earnestness of purpose in wishing to encourage private sector development. Privatization is considered one of the litmus tests of the business climate by would-be investors for many reasons. When private companies are expected to compete with state enterprises they fear, out of their experience in a great many countries, that their public sector competitors may enjoy certain advantages such as priority access to funds and the ability to build up payment arrears. They may also worry about competing against firms that can sell their output at below-market prices, or about having to purchase uncompetitive inputs from state-owned firms. Last but not least, sales of state enterprises are for all intents and purposes irreversible, and therefore have strong emblematic value. Of course, to enhance credibility with investors, privatization also should be done (and seen to be done) according to the rules; the negative reactions of would-be foreign investors to a recent decision by the government of Zimbabwe to bypass established tendering procedures in the sale of 51 percent of a large power station illustrates the point.
Third, where major banks are still state owned, privatizing and gradually deregulating the banking system at the same time that supervision is being strengthened, and so enabling the system to function more efficiently, should be very high on the agenda. FIAS has found that availability of domestic financing is a key factor in attracting FDI.
Fourth, many low-income countries would benefit from harmonizing their investment codes and other rules of the game, including their monetary regimes, with those of their neighbors, so as to enlarge their markets.
IFC has been helping companies and governments increase foreign direct investment flows. This includes privatization advice (on the seller’s or the buyer’s side), technical assistance through FIAS, and most important, IFC’s own investments, a large proportion of which include foreign direct investors. During the past 40 years, IFC has accumulated an enormous amount of practical experience in helping to put together viable projects in difficult business environments, many in tandem with foreign corporations. Indeed, a major part of IFC’s business is providing a measure of comfort to foreign corporations that might otherwise decide not to invest in low-income countries. So during the past three years IFC invested $800 million in low-income countries, of which $475 million was in the larger ones (India, China, and Pakistan) and $330 million was in 30 smaller economies. In 27 of the low-income countries, IFC accounted for more than 10 percent of total private inflows, in many cases considerably more than 10 percent. All in all, IFC is a powerful catalyst attracting private investment to the poorer countries of this world.
One last thought. International capital flows are very important to development. When they supplement domestic savings and, in the case of FDI, bring in valuable technology, managerial expertise, and export marketing networks, they can accelerate development. Where the macroeconomic environment is right, portfolio flows can also contribute powerfully to development by leading to the creation of better and more credible capital market institutions. This has been the experience, for example, of Mauritius. But the experience of Mexico and a number of other countries shows that where confidence is lacking, savings are low, and the local population is inclined to transfer funds abroad, foreign capital will merely displace domestic savings.
Chafuen, Alejandro, and EugenioGuzman, 1996, Libertad Economica y Corruption (Santiago: Instituto Libertad y Desarrollo).
The Economist, 1996, “Asia’s Costly Labour Problems,”September21, p. 62.
After the Mexican crisis of 1994, much has been said of the pitentiai destabilizing effects of portfolio investment. Indeed, portfolio investment can be destabilizing, but this occurs mainly when the macroeconomic situation of the host country is seriously out of balance, in particular when the exchange rate is overvalued and domestic savings are low. Under such conditions, the “disciplinary” effects of portfolio investment on capital market institutions may give way to a “displacement effect” where foreign capital is pouring in while local residents are safeguarding their own savings abroad, as was the case in Mexico during the run-up to the 1994 crisis.
”Low-income” is defined here according to the World Bank Atlas, 1996, that is, countries with a GNP per capita of $725 or less in 1994 (see map p. 20 of the Atlas).