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FDI Trends


									NOTE NUMBER 273

                                                                                                                                 P U B L I C           P O L I C Y           F O R         T H E


                                                                                                              FDI Trends
                                                                               Vincent Palmade and            Looking Beyond the Current Gloom in Developing Countries
                                                                               Andrea Anayiotas
                                                                                                              T h e f a l l i n f o re i g n d i re c t i nve s t m e n t ( F D I ) s i n c e 1 9 9 9 , a n d C h i n a ’s
                                                                               Vincent Palmade
                                                                                                              g row i n g s h a re , wo r r y m o s t d eve l o p i n g c o u n t r i e s . B u t a n i n - d e p t h l o o k
                                                                               ( is a
                                                                               lead economist at the          reve a l s n ew a n d p ro m i s i n g t re n d s . T h e d e c l i n e i s l a rg e l y a o n e - t i m e
                                                                               Foreign Investment

                                                                                                              a d j u s t m e n t f o l l ow i n g t h e p r i vat i z at i o n b o o m o f t h e 1 9 9 0 s . F D I i s
                                                                               Advisory Service in the
                                                                               Private Sector                 c o m i n g f ro m m o re c o u n t r i e s — a n d g o i n g t o m o re s e c t o r s . T h e
                                                                               Development Vice               c o n d i t i o n s f o r at t r a c t i n g F D I va r y by s e c t o r : i n l a b o r - i n t e n s i ve
                                                                               Presidency, a joint facility
                                                                               of the World Bank and
                                                                                                              m a n u f a c t u r i n g , f o r ex a m p l e , e f f i c i e n t c u s t o m s a n d f l ex i bl e l a b o r
                                                                               International Finance          m a r ke t s a re key, w h i l e i n re t a i l a c c e s s t o l a n d a n d e q u a l e n f o rc e m e n t
                                                                               Corporation. Andrea
                                                                                                              o f t a x r u l e s m at t e r m o s t . S o r t i n g o u t t h e m i c ro e c o n o m i c i s s u e s by
                                                                               Anayiotas is a consultant
                                                                               with the Foreign               s e c t o r w i l l b e g o o d n o t o n l y f o r F D I b u t a l s o f o r d o m e s t i c i nve s t o r s .
                                                                               Investment Advisory
                                                                                                              The flows of foreign direct investment (FDI) to                remained low. Eastern European countries are
                                                                                                              developing countries have declined by 26 per-                  counting on integration with the European
                                                                                                              cent since 1999, while China’s share has                       Union to help renew FDI flows.
                                                                                                              increased from 21 percent to 39 percent (figure
                                                                                                              1). The large flows of FDI to banks and utilities              Reasons for hope
                                                                                                              dwindled following a series of disappointments                 But a more in-depth look suggests a more com-
                                                                                                              for both investors and governments. China now                  plex and hopeful story. Despite the decline in
                                                                                                              has a commanding lead in manufacturing, with                   FDI since 1999, its growth over the past 13 years
                                                                                                              a large, qualified, low-cost, and flexible work-               has been phenomenal, averaging more than 17
                                                                                                              force. India seems to be following suit in the                 percent annually in dollar terms. The decline
                                                                                                              promising offshore services sector.                            since 1999 is due mostly to the drop in FDI fol-
                                                                                                                  As a result of all this, many developing coun-             lowing the boom in huge (one-time) privatiza-
                                                                                                              tries regard their prospects for FDI as bleak.                 tion deals in the infrastructure, financial, and
                                                                                                              The gloom is particularly strong among Latin                   petroleum sectors in the 1990s. FDI in other sec-
                                                                                                              American and Southeast Asian countries, once                   tors remained fairly constant (figure 2). This
                                                                                                              the darlings of foreign investors. FDI levels in               cyclical effect is confirmed by the much starker
                                                                                                              Africa, the Middle East, and South Asia have                   “rise and fall” pattern in FDI flows to industrial

                                     Foreign direct investment flows to                                                       to excessive returns. The financial and infra-
                                Figure developing countries, 1990–2003                                                        structure sectors are tricky to regulate as quasi-

                               1      US$ billions

                                                                                                                              natural monopolies, but FDI is not to blame for
                                                                                                                              government shortcomings.
                                                                                                                                  In sectors where competition is stronger, FDI
                                                                                                                              has had a much more obvious positive impact. A
                                                                                  All other
                                      100                                        developing                                   study of India by the McKinsey Global Institute
                                                                                  countries                                   (2001) showed that the removal of FDI restric-
                                                                                                                              tions in the automotive sector unleashed com-
2                                                                                   China
                                         0                                                                                    petition and investments, resulting in a
                                         1990         1992       1994       1996 1998               2000              2003a   threefold increase in productivity that trans-
                                    a. Estimated.                                                                             lated into a threefold increase in output due to
                                    Source: World Bank 2004.
                                                                                                                              falling prices (figure 3). Employment also rose.
                                                                                                                                  So, once adjusted for the one-time events and
                               countries over the same period. Another (hope-                                                 government shortcomings, the fundamental
                               fully one-time) factor driving the decline has                                                 picture of FDI is quite positive.
                               been the macroeconomic crisis and uncertain-
                               ties affecting Latin America.                                                                  China in perspective
                                                                                                                              China’s commanding FDI performance also
                               Positive impact on development                                                                 should be put into perspective. While China
                               While many observers believe that much of the                                                  accounts for 39 percent of the FDI to develop-
                               FDI in the financial and infrastructure sectors                                                ing countries, it also accounts for almost 30 per-
                               yielded little impact, this perception does not                                                cent of the developing world’s population. In
                               stand up to in-depth analyses such as those by                                                 fact, relative to GDP, China’s performance in
                               Luis Guasch (2002), Clive Harris (2003), and                                                   attracting FDI is good but not extraordinary,
                               the McKinsey Global Institute (2003). These                                                    with FDI at 3.8 percent of GDP in 1999–2002.
                               studies have shown that in almost all cases FDI                                                Nineteen developing countries did better over
                               had a largely positive impact on productivity                                                  the same period. China’s performance looks
                               (the key criterion for assessing long-term eco-                                                even less extraordinary if adjusted for the
                               nomic performance) and on the coverage of                                                      round-tripping of FDI through Hong Kong
                               services. But ill-designed privatization processes,                                            (China), which some estimates suggest may
                               contracts, and regulations have often led to                                                   account for as much as 30 percent of total FDI
                               poor returns on investments or, in some cases,                                                 to China.

                                       Foreign direct investment flows to 20
                                                                                                                              New diversity in sources and destinations
                                       largest developing country recipients                                                  Another reason for hope is that the sources of
                                Figure by sector, 1998–2002                                                                   FDI are increasingly varied. “South-south” FDI

                               2       US$ billions

                                                                                                                              flows are expanding rapidly; they now account
                                                                                                                              for more than 30 percent of FDI to developing
                                                                                                                              countries, up from 17 percent in 1995. China
                                                                                                                              and South Africa are becoming major players in
                                                 Infrastructure, financial, and petroleum sectors                             Africa, for example, with about US$2.7 billion
                                                                                                                              and US$1.6 billion of FDI there by 2001, the lat-
                                        50                               Other sectors                                        est year for which statistics are available.
                                                                                                                                 That developing countries are growing
                                          1998                 1999            2000              2001                 2002    sources of FDI is doubly good news because
                                                                                                                              these new players tend to be better equipped to
                                    Source: Economic Commission for Latin America and the Caribbean, Association of
                                    Southeast Asian Nations, United Nations Conference on Trade and Development,              invest in difficult and remote markets and to
                                    and government statistics.
                                                                                                                              develop products and services better adapted to
       Impact of foreign direct investment in the Indian automotive industry
Figure Index: 1992–93 = 100

3                 Barriers
                 • Licensing
                                                 Labor productivity



                 • FDI allowed
                                                100                         100                       100                111

                                               1992–93       1999–2000    1992–93        1999–2000   1992–93       1999–2000
     Source: McKinsey Global Institute 2001.

developing country consumers. The Turkish                                Implications for governments
conglomerate Koc was the first company to                                So there is no reason for developing countries
open hypermarkets in the Russian Federation—                             to despair. But in an increasingly competitive
with great success. Chinese electronics produc-                          market, getting their fair share of FDI flows and
ers such as TCL know how to produce US$50                                benefits will be hard work. Attracting FDI will
color televisions in India and Vietnam, while                            require a shift in mind-set for most developing
Maruti Suzuki in India is ready to export cars for                       country governments.
US$2,000. These are low-spec products, but they
are exactly what consumers in developing coun-                           Broadening the scope of FDI
tries need, as they often face the unhappy choice                        To start with, the scope of efforts to attract FDI
between high-spec but unaffordable “Western”                             must encompass all economic sectors. The ten-
products and very low-spec but relatively expen-                         dency in the past was to focus almost exclusively
sive traditional products.                                               on infrastructure and on efficiency-seeking and
    Yet another reason to be hopeful is that the                         tariff-jumping FDI in manufacturing. In the
destination sectors of FDI also are becoming                             future more and more FDI will be market-
more varied. FDI has evolved from focusing pri-                          seeking investment in service sectors as well as
marily on natural resources, infrastructure, and                         investment in tourism and offshore services.
manufacturing (export-driven or “tariff jump-                            Most developing countries continue to restrict
ing” investment) to also covering banking, retail,                       FDI in service sectors (for example, India does
construction, tourism, and offshore services.                            not allow FDI in retail), yet are ready to waste for-
Cumulative FDI flows to the retail trade sector in                       tunes to attract efficiency-seeking FDI for manu-
the 20 largest developing countries amounted to                          facturing in an uphill battle against China.
US$45 billion in 1998–2002 (about 7 percent of                              There is a general misconception that
the total to these countries). That too is good                          market-seeking FDI in domestic sectors such as
news, since more and more countries can hope                             retail yields little development impact. The
to develop comparative advantages in a few of                            opposite is true. FDI in retail has been a key
these new sectors. Moreover, FDI is increasingly                         driver of productivity growth in Brazil, Poland,
market seeking rather than efficiency seeking                            and Thailand, resulting in lower prices and
(that is, export driven), offering opportunities to                      higher consumption. Large-scale foreign retail-
any country willing to open its markets or inte-                         ers are also forcing wholesalers and food proces-
grate with its neighbors.                                                sors to improve. And they are now becoming
    These encouraging FDI trends in the devel-                           important sources of exports: Tesco in Thailand
oping world should be expected to continue,                              and Wal-Mart in Brazil are increasingly turning
since they mirror what has happened in the                               to local products to feed their global supply
industrial world.                                                        chains. Retail also happens to be a pillar of the

tourism industry. The misconceptions about FDI         Note
are made worse by political economy factors:              1. The importance of microeconomic barriers to growth
while attracting efficiency-seeking FDI does not       has been documented in great detail by the World Bank’s
affect incumbents, attracting market-seeking           Investment    Climate     Assessments     (
FDI usually does.                             and Doing Business
                                                       studies ( Business/) as
Tackling microeconomic issues                          well as by the McKinsey Global Institute’s industry-level
In addition to broadening the scope of efforts,        analysis (
                                                                                                                         is an open forum to
countries must recognize that the battle for FDI
                                                                                                                         encourage dissemination of
will increasingly be fought at the microeconomic       References
                                                                                                                         public policy innovations for
level sector by sector. Of course, foreign                Guasch, Luis. 2002. “The Experience of Latin America
                                                                                                                         private sector–led and
investors will continue to insist on basic political   with Performance-Based Contracts.” World Bank, Latin
                                                                                                                         market-based solutions for
and macroeconomic stability, but this should           America and the Caribbean Region, Finance, Private                development. The views
become less important as a differentiating factor.     Sector, and Infrastructure Unit, Washington, D.C.                 published are those of the
Investors will look increasingly at micro-                Harris, Clive. 2003. Private Participation in Infrastructure   authors and should not be
economic conditions, and what they look for will       in Developing Countries: Trends, Impacts, and Policy Lessons.     attributed to the World
vary significantly from one sector to another.         World Bank Working Paper 5. Washington, D.C.                      Bank or any other affiliated
    The requirements for efficiency-seeking               McKinsey Global Institute. 2001. India’s Growth                organizations. Nor do any of
investment in manufacturing are increasingly           Imperative. Mumbai.                                               the conclusions represent
well understood—low factor costs, a flexible              ———. 2003. New Horizons. San Francisco.                        official policy of the World
labor market, a small regulatory burden, effi-            World Bank. 2004. Global Development Finance 2004:             Bank or of its Executive
cient infrastructure and customs. Less obvious         Harnessing Cyclical Gains for Development. Washington, D.C.       Directors or the countries
factors include easy access to a competitive sup-                                                                        they represent.

plier base and business service providers.
    The factors required to attract FDI in domes-                                                                        To order additional copies

tic services are vastly different—a stable and                                                                           contact Suzanne Smith,

smart regulatory environment for quasi-natural                                                                           managing editor,
                                                                                                                         Room I9-009,
monopolies (a hard-won lesson from the
                                                                                                                         The World Bank,
1990s), functioning land markets for retail,
                                                                                                                         1818 H Street, NW,
hotels, and construction. In addition, unfair
                                                                                                                         Washington, DC 20433.
competition from tax-evading, low-productivity
informal players has been found to be among
the biggest constraints to FDI growth in domes-
                                                                                                                         001 202 458 7281
tic services in most developing countries, and it
tends to get worse over time.1
                                                                                                                         001 202 522 3480
    Resolving the microeconomic issues sector                                                                            Email:
by sector will be good for FDI as well as for                                                                  
domestic private investors—and thus key to
boosting growth and reducing poverty. But most                                                                           Produced by Grammarians,
developing countries have a long way to go.                                                                              Inc.

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