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Asian Development Outlook 2004 : III. Foreign Direct Investments in Developing Asia
Conclusions and Policy Implications Several key points emerge from this survey of approaches to, and experiences with, FDI. Notwithstanding their diversity, almost all developing Asian economies have adopted progressively more open policies toward FDI during the past decade or two, and this trend appears likely to continue. This more open posture has been accompanied by the adoption of more liberal trade regimes, a process that has had profound implications for the motives for, and impact of, foreign investment. These changes have been so rapid in some cases that the policy framework has been unable to keep pace. Apart from these key points, it is increasingly difficult to characterize and typify foreign investment. In most economies, it enters practically all sectors. It originates from industrial and developing economies. It may take the form of long-term greenfield investment or short-term, opportunistic M&As. It ranges from the global investments of the world’s largest corporations to smaller cross-border investments. The distinction between foreign and domestic investment is increasingly blurred, especially when a country’s diaspora is actively involved. A world of increasingly seamless national boundaries also connotes highly fluid capital whose national characteristics are often difficult to discern. The general conclusion in the empirical literature is that FDI confers net benefits on the host economy. The capital stock is augmented, productivity rises, and some (often much) of the increase is appropriated by domestic factors of production. These benefits appear to be especially important in connecting the host country to the global economy, and in the area of technology transfer. Nevertheless, analysts still keenly debate the magnitudes, channels, and lags associated with these transfers. In assessing the impact of FDI, a key issue is one of attribution, in the sense of discerning causality. Some opponents argue that the entry of FDI may be associated with negative effects, such as rising interpersonal or within-country inequality, the demise of petty traders, increased concentration of ownership, higher levels of pollution, and more corruption. The challenge in each case is to determine whether there is any causality in the relationship. In most cases, the causality appears to be either weak or nonexistent. For example, pollution normally rises as countries pass through a transitional phase of industrialization characterized by greater pollution intensity. Petty traders and cottage industry experience difficulty competing with large retail outlets and factory-scale production regardless of who owns the latter. Regional inequality (both within individual countries and among groups of countries) often rises during the process of globalization, as those regions in the domestic economy better connected to the global economy have the capacity to grow faster. One cannot help but note in passing that some of the strongest criticisms of MNEs emanate from countries with the smallest FDI presence. It is also important to emphasize that MNEs generally adapt to the local commercial environment. Any assessment of their impact needs to make due allowance for this factor. For example, if corruption is deeply embedded in the host country environment, MNEs are presumably likely to adjust to this characteristic (subject of course to source country restrictions). If tax evasion via transfer pricing occurs, it could be because tax rates are significantly above comparable benchmarks and such evasion is a general feature of local corporate behavior. If the incentives regime is strongly biased against exports, employment, or balanced regional development, MNEs cannot reasonably be expected to behave any differently from local firms. Limited technology spillovers are likely to be present when the domestic human capital base is weak. It is unlikely that MNEs will maintain high environmental standards if the general policy environment is lax in this respect. In other words, it is important to diagnose the root cause of a particular problem, rather than engage in an exercise of “guilt by association.” Investment measures have long been a feature of the regulatory framework governing FDI in most host countries. Most measures were designed to transfer benefits from the operations of foreign firms to the local economy and to promote development objectives. In essence, the primary objective of these measures is for host countries to obtain the maximum possible share of the gains from FDI. However, such regulations distort trade and investment and impose welfare losses (Moran 2002). The various regulations used may in fact have weakened, rather than enhanced, the contribution of FDI to national development objectives. In terms of incentives, there is some evidence that incentives play a relatively minor role in MNEs’ decisions about where to locate relative to other location-based considerations (Ganesan 1998; Balasubramanyam 1991). Moran (2002) has provided much evidence to show how counterproductive and damaging domestic content requirements and joint-venture requirements can be for host country development. He also demonstrates just how beneficial a policy-of allowing subsidiaries that are wholly owned and unfettered by local content mandates-can be for host country growth and development. Investment measures have frequently turned out to be costly and inefficient. Many countries, both industrial and developing, have abandoned or scaled back their use. Perhaps the most telling empirical evidence on this issue is not the number of governments that have such policies, but the number of governments that have reduced them. Indeed, one key feature of the use of policies, such as local content schemes and export performance requirements, is that they are becoming less popular. Therefore, the appropriate question to ask is whether there are reasonable grounds for adopting or maintaining such policies. The most frequent answer to this question is that these policies are required to “develop” specific industries in order to compete in an open trading environment. Another reason sometimes cited is that structural adjustments involved in removing these types of policies will result in unemployment and loss of technology transfer and opportunities to move into high-technology industries (Bora 2001). The core of the debate on the use of these policies is typically referred to as the “development dimension.” In this context, the term development includes elements of self‑sufficiency, national pride, and, perhaps most importantly, employment. It also has a technology transfer dimension, where FDI is supposed to induce technology transfer into developing countries. Protection may induce expansion of output and employment in certain sectors, although this expansion often carries a substantial cost for the society implementing such a policy. The upsurge in FDI to developing countries in the 1990s was largely caused by unilateral liberalization of their FDI policies and regulatory regimes. Theoretical and empirical evidence provide strong support for the proposition that neutral policies designed to enhance the efficiency of investment are better suited to attracting foreign investment and enhancing its contribution to development than interventionist methods (Bora 2001). The challenge in multilateral negotiations on trade and investment is to identify the best ways to foster economic development while taking into account the specific conditions and policies prevailing in a developing country. Ariff (1989) points out that some investment measures appear to be redundant. For example, export performance requirements that set minimum export-output ratios to qualify for incentives or perks are scarcely binding in the sense that firms are required to do what they would have done anyway, even in the absence of explicit performance requirements. A central issue is whether investment measures actually alter the allocation of resources in production and trade or merely affect the distribution of rents between firms and host countries. Both suppliers and recipients of FDI gain from the liberalization of investment measures. Foreign investors may benefit from new investment opportunities resulting from liberalized investment regulations, while host countries may benefit from increased FDI inflows and greater market discipline resulting from this. Since many developing countries compete with one another to offer foreign investors generous fiscal, infrastructure, and financial incentives, the scaling down of investment incentives could yield additional revenue for the host country governments. The international benefits of FDI appear to be highly uneven. For some countries the benefits of an MNE presence are clear, while for others the impacts are ambiguous or possibly negative. Since all countries face the same international commercial environment, the presumption is that host country policy regimes and institutional capacities are the deciding factors of these differences. This section therefore concludes with a discussion of seven salient policy issues. (1) Flexible and Adaptable Regulatory Environment. A major challenge for policy makers is keeping up with a rapidly changing international commercial environment. The calculation for mobile, export-oriented, foreign investors differs from that for investors in the import substitution era. The quality of incentives, institutions, and infrastructure matters more than before. In transitional economies, the first round of reforms typically focuses on macroeconomic stabilization and partial trade liberalization, while other, microeconomic, components of the “three Is” typically lag. The question arises as to whether the FDI regulatory framework adapts adequately to this fast-changing environment. Inert and bureaucratic investment agencies, accustomed to distributing and exacting rents, may not be able to change quickly enough. Over a decade ago, Wells and Wint (1991) observed that, with the exception of Singapore, these agencies struggled with their dual, and potentially conflicting, identities as both promoter and regulator of FDI. These agencies have rarely been in the forefront of major economic policy reform. A mind-set remains that views FDI primarily as for “greenfield” investment rather than for M&As. The rise of the new economy in various guises is transforming international business patterns. Even in relatively successful and long-lived cases of regional economic cooperation, such as ASEAN, the notion of a seamless market and business environment is still far from realization. (2) Unfinished Reform Agenda. Significant obstacles to FDI are still in place, and these are typically more substantial than trade barriers. Many of them are concentrated in services industries, notwithstanding the significant liberalizations of the past decade.36 In fact, countries with a tradition of openness toward merchandise trade have often been quite restrictive on services trade and FDI in services sectors. Malaysia, Thailand, and even Singapore may be included in this characterization. Of course, there may be good grounds for rejecting certain FDI applicants, when their presence would harm national interests.37 Moreover, governments everywhere have to bend to nationalist sentiment, particularly in the wake of economic crises when there is a perception that deep-pocketed foreigners are picking up distressed assets at fire-sale prices. Nevertheless, it needs to be recognized that, for all the rhetoric of “open borders,” major commercial barriers still exist. (3) Different Countries, Different FDI Issues. The diversity of the country sample discussed above draws attention to the fact that host countries have diverse expectations for FDI. For late reformers, a major objective is simply entering the international commercial mainstream. Thus “bagging the first contract” is a prime objective. For resource-rich economies, taxation and environmental arrangements, and the rate of resource depletion, feature prominently. For low-wage, densely populated economies, export-oriented labor-intensive FDI can be crucial. By contrast, as host economies lose their comparative advantage in the latter, attention shifts to how FDI may play a role in the process of upgrading to more technology-intensive activities. Where there already exists a strong domestic R&D base, policy makers can seek to build on these strengths through joint ventures with MNEs. The key point, therefore, is that, while the notion of one size fits all may apply at the general level to the adoption of open trade and investment regimes, there is in addition much scope for specific micro interventions to maximize the benefits of the foreign presence. (4) Toward a Unified Investment Environment. A major challenge for policy makers is the introduction of a unified investment regime that confers national treatment on foreign investors, except when they deem domestic ownership to be essential (on the basis of carefully articulated national interest arguments).38 Foreign and domestic investors are generally concerned with the same set of policy issues-including the tax regime, labor relations, the quality of human capital and infrastructure, and adequate legal protection. There is therefore little point in attempting to devise different policy regimes for foreign firms. Invariably, MNEs are attracted to a commercial environment that domestic firms find conducive. The question of national treatment for FDI is particularly important in transitional economies. As part of the opening-up process, their policy makers recognize the importance of attracting MNEs into a hitherto hostile commercial environment. It is therefore not uncommon for them to “overdo” the FDI incentives regime by offering excessively generous arrangements for foreign investors. This results in the familiar dual policy regime, and often in round-tripping. Moreover, since these transitional economies also typically have a large, unreformed, and subsidized SOE sector, a lopsided ownership structure frequently emerges in which domestic private firms are underrepresented. In such circumstances, if domestic opposition to these privileged arrangements intensifies, the reform process itself could be jeopardized. (5) FDI and Trade Issues, Again. Foreign investors have changed orientation from rent seeking to efficiency seeking. Underpinning this transformation in Asia has been trade liberalization, which has been primarily unilateral in nature and supported by a conducive multilateral environment. These twin pillars are under challenge as never before. The momentum for multilateral trade reform appears to have slowed down, especially with the disappointing results at the Cancun WTO meeting in 2003. Bilateral and regional preferential arrangements, discriminatory in nature, are proliferating. There is a danger that a world of “hubs and spokes” may emerge, under which trade barriers between the spokes could increase. Such a trend would constitute a reversal from the postwar trend toward a more liberal global environment. It would also frustrate the emergence of the global factory phenomenon, and the capacity of MNEs to source globally at the lowest cost. It is therefore possible that, if the current predilection for preferential trading arrangements intensifies, MNEs will be forced to incorporate discriminatory trade barriers in their location decisions. For host economies, being a predictable and efficient production site would thus be a necessary but not sufficient condition for attracting FDI. (6) FDI in Decentralized Policy Environments. Over time, the power of central governments in many countries is likely to diminish, as authority devolves to the regional level. In transitional economies such as the PRC and Viet Nam, this process is an inevitable outcome of the shift from the planned to the market economy. In Thailand, the process is a deliberate one, as a major decentralization program was introduced in 1993. India and Malaysia are already federal entities. As this process takes root, it is possible that energetic local governments within a country will begin to compete among themselves to seize business opportunities, in the process bypassing cumbersome national agencies. The challenge for national governments will be to encourage this competitive potential, while ensuring that it operates in a manner consistent with national development objectives.39 The structure of center-regional fiscal relations is also a key to the success of these reforms: severe vertical fiscal imbalances may starve subnational governments of the resources needed to facilitate growth, and typically result in chronic “buck-passing” between tiers of government. (7) Fiscal Incentives. Fiscal incentives are a risky and generally costly means of attracting MNEs. They are invariably second best in nature, when a first-best approach would be to address at source the unattractive features of the host economy environment. If granted on a large scale, there is a risk that they will undermine the government’s fiscal base. Foreign firms are attracted to commercially profitable and politically stable environments. Surveys of MNEs invariably record these features as the major determinant of their location decisions when investing abroad. The empirical evidence also supports such a finding. Hong Kong, China, for example, has traditionally eschewed fiscal incentives in favor of a uniformly low tax regime. A report by the Foreign Investment Advisory Service on Thailand suggests that the payoff from incentives is very low. Moreover, in the absence of regime credibility, foreign investors implicitly discount the value of these incentives because they doubt their fiscal sustainability.40 Fiscal incentives are also corruption prone. Government officials can treat these “rents” as bargaining tools for corruption. It is quite common for up to half of their nominal value to be dissipated in this manner. In addition, they may be employed as a de facto instrument of industrial policy by agencies without the analytical capacity to devise and implement such programs. Performance criteria often lack any clear rationale; and are often not enforced anyway. Even in the well-managed Malaysian economy, for example, the rationale for the granting of incentives is ambiguous,41 and their opportunity cost has not been thoroughly assessed for a decade or more. There may be a case for distortions of these kinds in special circumstances. For example, investment incentives may be a useful signaling device in cases where governments are seeking to press their reform credentials in international business circles. In such cases, the key is to ensure that these are time bound, transparently costed, and transitional. To prevent vested interests from proliferating around these initiatives, they should desirably contain clearly defined and nonnegotiable sunset clauses. However, the political economy of reforming these incentives is complex. None of the six countries discussed above has been able to introduce major reforms in their incentives regime, despite the clear case for doing so. Regardless of the outcome of the Doha round of WTO negotiations, individual countries can adopt a policy framework that is beneficial to both foreign and domestic investors, as well as to recipient economies as a whole. Basic components of such policies would include transparency about investment rules and regulations, with clear identification of agencies responsible for issuing relevant licenses, permits, and approvals. With efficiency-seeking FDI, a liberal trade regime, and a competitive commercial environment, FDI can remain a win-win proposition for developing Asia.
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