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p. 64 of 69 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia III. Foreign Direct Investments in Developing Asia Trends Impact of Foreign Direct Investment Importance of the Policy Context International Investment Agreements Six Asian Case Studies Conclusions and Policy Implications Endnotes References

Asian Development Outlook 2004 : III. Foreign Direct Investments in Developing Asia

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Importance of the Policy Context

Whether-and the ways in which-FDI is beneficial or harmful to the host country depends on the context in which the investment takes place and in which the resulting economic activity operates. This is particularly true of the policy environment in the host country and especially in that local area of the host country where the investment is located. It is also true of policies that may be internal to the investing firm, such as transfer pricing.

The growing evidence that investment can make significant contributions to domestic development has increased the proliferation of incentives to attract such FDI. Government action at the national level can enhance FDI prospects by significantly reducing the uncertainty, asymmetric information (and related search costs), and other transaction costs (especially the amount of time and number of steps involved in acquiring approval) that are faced by foreign investors.

Tax breaks and subsidies are also common, but generally influence investment location decisions only at the margin. More important to most potential investors are the size and expected growth rate of the market that could be served, long-term macroeconomic and political stability, supply of skilled or trainable workers, and modern transportation and communications infrastructure. Once these criteria are satisfied, then financial incentives may influence the investor’s choice of suitable sites. More important, such incentives often create distortions and inefficiencies. Table 3.3 indicates the wide variety of both incentive- and rule-based measures commonly used to attract FDI. By distorting the relative costs for other sectors and investment projects that are not targeted for incentives, such schemes typically discriminate against smaller and domestic investors, as well as areas of actual or potential comparative advantage that are not recognized as such by policy makers. Over time, these actions can contribute to the development of a governance system that lacks transparency and accountability (JBICI 2002).

Incentives and regulations are often closely linked, such as when the former are granted subject to conditions. For example, many countries allow foreign firms majority ownership on condition that they export all or a significant proportion of their input. The length of tax holidays and the amount of tax credit granted often depend on, among other things, the market orientation of the venture and the local content of the output.

Arrangements that commit host country entities to purchase fixed quantities of output on a take-or-pay basis, and especially to pay in foreign currency, are common means of shifting risk from investors to the host government but can be detrimental to that government. This was evident in Southeast Asia during the Asian economic crisis when regional currencies depreciated sharply and swiftly but foreign investments in infrastructure, such as power plant investments in Indonesia and the Philippines, were based on continuing repayments in United States (US) dollars at rates that did not take the depreciation into account.

Too often, policies ostensibly designed to maximize net benefits of FDI for recipient economies have resulted in subscale manufacturing plants, frequently through mandated joint ventures, which are not allowed to source inputs freely and contribute little to the technological, social, or economic development of the country. Arrangements between foreign investors and host country authorities that block other new entrants to the industry or that inhibit alternative cheap sources of supply are also common but are generally not in the best interests of the host country. However, the host country can capture part of the rents from the scale economies through a licensing fee or an increase in factor prices in the export sector as foreign firms bid up factor costs above the level sustained by the small domestic export industry.

Incentives for foreign investors and benefits for the host economy will be less when the investments are directed toward serving small and protected domestic markets.¹⁶ The potential benefits to the host economy are greatest when international companies can exploit economies of scale both locally and globally, and are continually driven to update their technologies and managerial practices in order to remain competitive. Moreover, competition policy can strengthen the benefits associated with FDI for the host economy. As noted by the WTO working group on the interaction between trade and competition policy:

The point has been made in various oral and written contributions to the Group that the implementation of a transparent and effective competition policy can be an important factor both in enhancing the attractiveness of an economy to foreign investment, and in maximizing the benefits of such investment. More specifically, these contributions have suggested that competition policy can enhance the attractiveness of an economy for foreign investment by providing a transparent and principles-based mechanism for the resolution of disputes involving such investment that is consistent with international norms that are widely-accepted internationally. This increases investor confidence and therefore the propensity to invest. Vigorous competition in markets, reinforced by competition policy, also helps to maximize the benefits of such investment to host countries, by encouraging participating firms to construct state-of-the-art production facilities, to transfer up-to-date technology into host countries and to undertake appropriate training programmes, and by preventing the exploitation of consumers (WTO 1998, p. 8).

Investors will invest more of the latest proprietary technology and procedures when they feel that they have the greatest control over protection of the proprietary content transferred through the investment and greatest freedom in its use. Restrictions, such as forced sharing of technology through mandatory joint ventures, local content, or performance criteria, reduce the investor incentives to apply the most modern techniques and technologies, hindering integration into the global sourcing network of the parent company.¹⁷ Subsidiaries have been found to receive greater resources than partially licensed or partially owned or independent firms with lower transaction costs involved in technology transfer. Thus, multinational investment is found to be superior to direct licensing of technology to independent firms. Technology transfer and interchange of managers and technicians between parent and subsidiary firms have been found to be significantly higher for wholly owned subsidiaries than for joint-venture partnerships or licensees (Ramachandran 1993).

Hopes have faded that import-substituting industries benefiting from infant industry protection would grow to become globally competitive. So have hopes that domestic content and joint-venture requirements for foreign investors would stimulate domestic supply chains. In fact, empirical evidence has accumulated in the 1990s that the reverse is actually more likely. FDI facilitates integration into international supply chains, allowing host economies both to increase efficiency of existing activities and to enter into new economic activities. Allowing wholly owned affiliates of foreign firms the freedom to source from wherever they consider most advantageous is more likely to lead to domestic suppliers achieving economies of scale and becoming integrated into global supply chains, often under the direct supervision of the foreign buyers. Foreign buyers have increasingly helped local suppliers export first to sister plants and later to independent purchasers in order to lower the suppliers’ costs of production through economies of scale, thereby promoting contract manufacturing as an implicit new infant industry development strategy. Externalities in adoption of production, quality control, and managerial processes (including export coaching) frequently spread vertically within the invested sector and eventually to other sectors in the host economy (Moran 2002).¹⁸ 

National-level programs to promote the development of linkages between foreign-invested firms and domestic firms commonly include: (i) provision of market and business information; (ii) matchmaking by such means as trade fairs or databases; and (iii) support to local enterprises through provision of managerial and technical assistance, training, audits and, occasionally, by financial assistance or incentives (UNCTAD 2001, p. 183).

The Economic Development Board of Singapore has successfully encouraged foreign investors to voluntarily serve as scouts to identify promising local suppliers and then contribute to vendor development. This sort of buildup strategy is most effective in a conducive economic environment, i.e., one that provides low inflation and a realistic exchange rate, that rewards saving and investment, and that encourages legal and regulatory consistency (Moran 2002). Not only does the high return to capacity building pay off in terms of income, it attracts additional FDI in higher-skill areas, encouraging progression from lower to higher skilled activities with consequent social improvements in worker treatment.

With strengthened interest in human resources development and skill formation in the context of FDI policy, many countries regulate the hiring of foreign workers and impose training requirements on foreign investors. Malaysia is one example that has provided incentive schemes to promote technical and vocational training (JBICI 2002). In general, attracting internationally mobile factors of production will increasingly require host countries to improve the quality of their immobile assets.

Protection of intellectual property rights also plays an important role in attracting advanced technology production processes. Weak intellectual property protection deters foreign investors in technology-intensive sectors that rely heavily on intellectual property rights, and encourages investors to undertake projects focusing on distribution rather than local production (Smarzynska 2002). Primarily to protect property rights of foreign investors, but also the interests of host countries, there has been a surge of interest in international investment agreements, discussed in greater detail in the following section.

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