Challenges in an evolving context: How to maximise the benefits of FDI?

26 April 2017

Leveraging FDI for sustainable development — understanding the latter concept as a process leading to a constant social, economic and environmental upgrading — entails at least recognising three fundamental propositions. First, FDI is key to connect domestic economies to flows of capital and GVCs, increase productivity through diffusion of technology and know-how, and generate more and better jobs. In this article, the author outlines a comprehensive approach to investment policy and promotion along the five stages of the investment cycle in order to leverage FDI for sustainable development and optimise its potential benefits. Finally, the author argues that there are different types of FDI with varied impacts on development, thus there is a need for more nuanced policy mixes.

 

For many decades, academia and policymakers have debated about the role of foreign direct investment (FDI) in development. Such a question has been difficult to elucidate, not only because the discussion has been coloured by many ideological dogmas, but also because the very fundamental characteristics of cross-border investment have evolved over time.

Indeed, over the last five decades, the paradigm of FDI has changed significantly. FDI has previously been visualised as a flow of capital, moving from “North” to “South,” by big multinational enterprises (MNEs) from industrialised countries investing in developing countries, traditionally aiming to exploit natural resources in the latter or to substitute trade as a means to serve domestic consumption markets.

Today, FDI no longer flows from “North” to “South”, but also from “South” to “South” and from “South” to “North.” It is now not only carried out by large MNEs, but also from relatively smaller firms from developing countries that are investing beyond their home countries.

Further, FDI is no longer a substitute for trade, but quite the opposite. Today FDI has become part of the process of international production by which investors locate in one country to produce a good or a service that is part of a broader global value chain (GVC). Investors, then, have become traders and vice versa.

Last but not least, cross-border investment is no longer only about portfolio investment and FDI. International patterns of production are leading to new forms of cross-border investment, in which foreign investors share their intangible assets such as know-how or brands in conjunction with local capital or tangible assets of domestic investors. This is the case of non-equity modes of investment (NEMs) such as franchises, outsourcing, management contracts, contract farming or manufacturing.

Attracting and maximising the potential benefits of FDI

With adequate policies, FDI can provide significant economic and social benefits to host countries. For example, FDI can help create higher-skilled and better-paid jobs, promote the transfer of knowledge, raise productivity, and diversify and upgrade the value‐added component of exports — all of which affect a country’s ability to integrate with GVCs.

Evidence shows that FDI is a necessary – although not sufficient – condition for sustainable development, understanding the latter concept as a process leading to a constant social, economic and environmental upgrading. Right now, the international economy is evolving along a non-sustainable trend, not only environmentally, but politically and economically.

We are living in a paradoxical world. On the one hand, the fight against extreme poverty has been quite successful. The rates of extreme poverty have almost decreased by half over the last three decades. However, despite the significant reduction in poverty in the developing world, inequality is increasing. In fact, the distance between the richest and poorest economies in the world has multiplied by a factor of several hundred in the last two centuries. The gap in inequality is associated with increasing gaps in productivity between developed and developing countries.

In this context, the role of FDI is crucial. FDI is not so much about money, it is about the transfer of know-how which is key to tackling that gap in productivity. We all know about the importance of education and knowledge for economic development. What is less obvious is where that knowledge is obtained: at school? Sure, but more importantly, at work.

Observing the growth of income per capita in developing countries, research has shown that there is no direct correlation between the years of formal schooling and economic productivity. It may have a lot to do with the fact that technical knowledge requires people interacting with each other, and such interaction is no longer limited to schools, but more often in firms. Thus, firms are the new schools where technical knowledge is transmitted. The practical implication of this finding is crucial: it is in the best interest of developing countries to facilitate the presence of FDI in their territories to enable their nationals to interact with foreigners in order to encourage that transfer of technical knowledge.

However, this phenomenon does not always translate in practice. For many decades, developing countries have attracted large quantities of foreign investment and yet many of them have failed to move up the value chain. This implies that the potential benefits and spillovers of FDI are not automatic. Therefore, in order to optimise the development impacts of foreign investment, a suitable investment policy framework is needed.

Defining such a framework however is difficult and the trouble starts when decision-makers try to identify what “investment policy” is or should be. A huge range of stakeholders, problems, institutions, legal instruments, and administrative tools are captured in that concept. Countries get lost. Even if policymakers can identify a destination, it can be difficult to know where to start, to know which concrete actions will have the most impact.

Many developing country governments face difficulties in investment policy formulation, coordination and implementation, thus undermining their competitiveness and compromising the ability to attract and benefit from investment. A common mistake is that countries create investment policies to react to the old challenges posed by the type of investment they are already receiving. Instead, a state also needs to identify the opportunities to receive greater benefits from existing investments, and consider what other types of investment the country needs in order to develop. I will develop this further below.

As a first stage in tackling these challenges, recent research from the World Bank has examined econometric and case-study evidence about how good investment policies can help maximise the potential benefits of FDI, including insights about transforming domestic productive sectors by increasing participation in GVCs.  It is not enough for governments to lure FDI, it is also necessary to enable its establishment and, most importantly, to foster the expansion and “rooting” of the initial investment into the host economy. Such results may be reached not only by providing a stable environment for investors to operate and expand their original investments, but also to foster linkages between FDI and the domestic private sector.

Thus, the maximisation of potential benefits of FDI can be visualised as a five-stage cycle in which governments must: (i) develop a vision and strategy; (ii)  then pursue to attract the investment by smart promotion activities; (iii) enable and facilitate the entry and establishment of FDI in the host economy by reducing as much as possible the legal and procedural and de facto barriers preventing the establishment of FDI; (iv) facilitate the operation and expansion of investments by making sure that, among other factors, regulatory conduct of the public administration does not undermine the expansion of investments;  and finally (v) link the latter FDI with the domestic economy by undertaking measures enabling local suppliers to upgrade the quality, quantity or price of their production and by facilitating transactions with anchor investors.

Could research become more “digestible” for policymakers? 

Many government officials ask us: if FDI has so many potential benefits, why are some developing countries that have attracted it for more than a century not yet developed? The answer is related not only to my last point on the need to implement policies in order to retain, expand and link FDI with the domestic economy. It also has a lot to do with recognising that not all FDI is the same, nor does it have the same economic, social and environmental impacts. We all know that FDI in mining is not the same as FDI in hotels, nor high value-added business services.

Thus, there is a need to come up with a framework sophisticated enough to differentiate different types of investment and at the same time be simple enough to be practical for policymaking. Although a substantial body of literature on the various impacts of investment policy and FDI exists, findings are derived from either an extremely case‐specific research focus – such as an analysis of FDI experiences in one particular country and sector during a given period – or an overly broad focus – as if FDI were a homogenous phenomenon. Very few studies differentiate within types of FDI in their analysis. The resulting gap makes it difficult for policymakers to organise the multiple, complex variables affecting a country’s ability to maximise investment benefits.

The paper suggests applying a logical framework that takes into account investor characteristics and motives in a more systematic manner. A first step would be to build on the FDI typology originally developed by John H. Dunning, that distinguished among different types of FDI on the basis of the main drivers behind of investors’ locational decisions – whether they are seeking natural resources, serving domestic markets, locating segments of international production processes, or aiming to acquire strategic assets.

Further, each type of FDI also generates different trade patterns. While natural resource-seeking FDI tends to generate exports of commodities and often an import pattern of manufacturing goods, domestic market-seeking FDI, although very important, may not necessarily lead to exports, but rather may in the end may entail greater imports and, if not well managed, protectionist trade policies. Efficiency-seeking FDI is by definition trade-related, as the investor simultaneously becomes an importer and exporter, while strategic asset-seeking FDI may also lead to greater integration with global value chains.

Although currently most countries tend to receive different types of FDI simultaneously – albeit one or two tends to predominate – from a historical point of view, and from the vantage point of developing countries, it is possible to identify a sequential rather than a simultaneous evolution of each type of FDI. From the perspective of the history of integration of developing countries into the world economy, natural resource-seeking FDI became the original vehicle of such integration. Indeed, from colonisation through the first stages of economic development, it was the exploitation of natural resources, and the FDI associated with it, that represented the main vehicle of internationalisation of developing economies, leading to a pattern in which the latter exported commodities and imported manufactured goods.

Later, during the 1940s-1980s when industrialisation tended to be visualised as the key vehicle for development, many governments pursued import-substitution industrialisation (ISI) policies which relied on domestic market-seeking FDI coupled with a protectionist trade policies. This fact explains why many developing countries were not part of the General Agreement on Tariffs and Trade (GATT). While the latter was calling for lowering tariffs for trade in goods, most developing countries were lifting tariffs to induce domestic market-seeking FDI through tariff jumping. The lack of a competitive industry and limited exports led to structural imbalances that eventually were not economically sustainable, and in the 1980s led to major structural adjustments. However, for four decades, the GATT managed to lower average tariffs for goods from 40 to 4 percent, generating significant competition among multinational enterprises, culminating in the development of efficiency-seeking FDI and patterns of international production. Thus, developing countries shifted their policies to attract this type of FDI and gradually joined the WTO and subscribed to other international investment agreements (IIAs) during the 1990s until today. Currently, with the emergence of outward investment from developing countries, we note that most of it tends to be strategic asset-seeking FDI.

Following a systematic application of this typology would allow many governments to design more effective reform packages around distinct investment characteristics. Governments are reforming, and they require knowledge that is both cogent and applicable to their specific contexts. While abundant and useful literature has been produced so far, tailoring research to the challenges of investment policy in practice will increase its relevance for countries seeking to enact reforms.

Conclusion

In sum, leveraging FDI for sustainable development entails at least recognising three fundamental propositions. First, FDI is key to connect domestic economies to flows of capital and GVCs, increase productivity through the diffusion of technology and know-how, and generate more and better jobs. Second, a comprehensive approach to investment policy and promotion, recognising the five stages of the investment cycle, is required to optimise the potential benefits of FDI. And third, there are different types of FDI with very different impacts on development, thus there is a need for more nuanced policy mixes.

 

Roberto Echandi is Global Lead, Investment Policy & Promotion at the World Bank Group.

The opinions expressed in this note are full responsibility of the author and do not represent the views of the World Bank Group.