An Overview of FDI

T.Y.
BMS Project Report on AN OVERVIEW OF FDI
SUBMITTED BY, CHIRAG NARESH CHAUDHARY T.Y.BMS [Semester V]
UTTARI BHARTI SABHAS RAMANANDA ARYA D.A.V. COLLEGE OF COMMERCE AND SCIENCE, BHANDUP (E).
SUBMITTED TO, UNIVERSITY OF MUMBAI ACADEMIC YEAR 2012-2013
PROJECT GUIDENCE BY PROF. SRIDHARAN SIR
DECLARATION
I, Mr. CHAUDHARY CHIRAG NARESH (Seat No. ) of R.A.DAV College of Science & Commerce of TYBMS [Semester V] hereby declare that I have completed my project, titled AN OVERVIEW OF FDI in the Academic Year 2012-2013. The information submitted herein is true and original to the best of my knowledge.
Signature of Student [CHIRAG CHAUDHARY]
UTTARI BHARTI SABHAS, RAMANANDA ARYA D. A. V. COLLEGE OF COMMERCE AND SCIENCE, BHANDUP (E) CERTIFICATE OF PROJECT WORK
This is to certify that Mr. CHIRAG NARESH CHAUDHARY of T.Y.B.M.S. Semester V (Roll No - 352) has undertaken & completed the project work titled AN OVERVIEW OF FDI during the academic year 2012-13 under the guidance of Prof. SRIDHARAN SIR submitted in SEPTEMBER, 2012 to this college in fulfillment of the curriculum of BACHELOR OF MANAGEMENT STUDIES, UNIVERSITY OF MUMBAI. This is a bona fide project work & the information presented is True & original to the best of our knowledge & belief.
PROJECT GUIDE
COURSE COORDINATOR (CHANDRAKALA SHRIVASTAVA)
PRINCIPAL (DR AJAY BHAMARE)
(SRIDHARAN SIR)
EXTERNAL EXAMINER
ACKNOWLEDGEMENT
With profound sense of gratitude and regard, I express my sincere thanks to my project guide Mr. SRIDHARAN SIR for his valuable guidance and the confidence he instilled in me, that helped me in the successful completion of this project report. Without his help, this project would have been a distant affair. His thorough understanding of the subject and professional guidance was indeed of immense help to me.
This project helped me a lot in getting more knowledge and experience in the field of Finance. This project has been very informative and interesting.
Signature of Student [CHIRAG NARESH CHAUDHARY]
An Overview of FDI
Analysis of different perspectives of FDI
By: Chirag Chaudhary
Index
1. Introduction to FDI .....................................................................................................................1 1.1. 1.2. 1.3. 1.4. 1.5. 2. What is Foreign Direct Investment (FDI?) .............................................................................1 Composition........................................................................................................................3 Determinants ......................................................................................................................4 Classification of Foreign Direct Investments .........................................................................4 Classification by Motivation ................................................................................................4
Current Global Scenario and Trends ............................................................................................8 2.1. 2.2. 2.3. 2.4. Global Overview..................................................................................................................8 Sector Highlights ............................................................................................................... 10 Regional Highlights ............................................................................................................ 11 Expansions: A Growing Part of FDI ..................................................................................... 20
3.
Contribution of FDI towards development................................................................................. 23 3.1. 3.2. 3.3. 3.4. Trends .............................................................................................................................. 24 FDI and Growth ................................................................................................................. 25 FDI and environmental and social concerns........................................................................ 36 Net Contribution of FDI to Developments .......................................................................... 38
4.
Political Considerations ............................................................................................................ 41 4.1. 4.2. Literature Review .............................................................................................................. 43 Discouragement by Political Risk to FDI.............................................................................. 44
5. 6.
Social Considerations ................................................................................................................ 56 Challenges ................................................................................................................................ 66 6.1. 6.2. 6.3. Host country policy measures ............................................................................................ 68 Home country policy measures .......................................................................................... 72 The right to regulate.......................................................................................................... 74
7.
Corporate Social Responsibility and FDI ..................................................................................... 78 7.1. 7.2. 7.3. Legal limitations on corporate accountability ..................................................................... 78 Power imbalances ............................................................................................................. 79 FDI liberalization ............................................................................................................... 80
8. 9. 10.
Conclusion........................................................................................Error! Bookmark not defined. Recommendations.................................................................................................................... 84 Bibliography ......................................................................................................................... 85
1.
Introduction to FDI
Foreign Direct Investment (FDI) from the viewpoint of the Balance of Payments and the International Investment Position (IIP) share a same conceptual framework given by the International Monetary Fund (IMF). The Balance of Payments is a statistical statement that systematically summarizes, for a specific time span, the economic transactions of an Economy with the rest of the world (transactions between residents and non-residents) and the IIP compiles for a specific date, such as the end of a year, the value of the stock of each financial asset and liability as defined in the standard components of the Balance of Payments. 1.1. What is Foreign Direct Investment (FDI?) According to the IMF and OECD definitions, direct investment reflects the aim of obtaining a lasting interest by a resident entity of one economy (direct investor) in an enterprise that is resident in another economy (the direct investment enterprise). The lasting interest implies the existence of a long-term relationship between the direct investor and the direct investment enterprise and a significant degree of influence on the management of the latter. Direct investment involves both the initial transaction establishing the relationship between the investor and the enterprise and all subsequent capital transactions between them and among affiliated enterprises4, both incorporated and unincorporated. It should be noted that capital transactions which do not give rise to any settlement, e.g. an interchange of shares among affiliated companies, must also be recorded in the Balance of Payments and in the IIP. The fifth Edition of the IMFs Balance of Payment Manual defines the owner of 10% or more of a companys capital as a direct investor. This guideline is not a fast rule, as It acknowledges that smaller percentage may entail a controlling interest in the company (and, conversely, that a share of more than 10% may not
An Overview of FDI
signify control). But the IMF recommends using this percentage as the basic dividing line between direct investment and portfolio investment in the form of shareholdings. From this moment, any further capital transactions between these two companies should be recorded as a direct investment. When a non-resident holds less than10% of the shares of an enterprise as portfolio investment, and subsequently acquires additional shares resulting in a direct investment (10% of more), only the purchase of additional shares is recorded as direct investment in the Balance of Payments. The holdings that were acquired previously should not be reclassified from portfolio to direct investment in the Balance of Payments but the total holdings should be reclassified in the IIP. Concerning the terms direct investor and direct investment enterprise, the IMF and the OECD define them as follows. A direct investor may be an individual, an incorporated or unincorporated private or public enterprise, a government, a group of related individuals, or a group of related incorporated and/or unincorporated enterprises which have a direct investment enterprise, operating in a country other than the country of residence of the direct investor. A direct investment enterprise is an incorporated or unincorporated enterprise in which a foreign investor owns 10% or more of the ordinary shares or voting power of an incorporated enterprise or the equivalent of an unincorporated enterprise. Direct investment enterprises may be subsidiaries, associates or branches. A subsidiary is an incorporated enterprise in which the foreign investor controls directly or indirectly (through another subsidiary) more than 50% of the shareholders voting power. An associate is an enterprise where the direct investor and its subsidiaries control between 10% and 50% of the voting shares. A branch is a wholly or jointly owned unincorporated enterprise. It should be noted that the choice between setting up either a subsidiary/associate or a branch in a foreign country is dependent, among other factors, upon the existing regulations in the host country (and sometimes in its own country, too). National regulations are often more restrictive for subsidiaries than for branches but this is not always the case.
An Overview of FDI
To establish the basic concepts related to FDI, following points should be noted: When a firm controls (or have a strong say in) another firm located abroad, e.g. by owing more than 0% of its equity, the former is said "parent enterprise" (or "investor") and the latter "foreign affiliate". Foreign Direct Investment (FDI) is the financial investment giving rise and sustaining over time the investor's significant degree of influence on the management of the affiliate. The initial investment can be the purchase of an existing firm (by acquisition or by merger, the so-called "M&A") as well as the foundation of a new legal entity who usually - but not necessarily - makes a green-field real investment (e.g. building a factory) in the foreign country [1]. In a broader definition, FDI consists of the acquisition or creation of assets (e.g. firm equity, land, houses, oil-drilling rigs) undertaken by foreigners. If in these enterprises they are not alone but act together with local firms and/or governments, one talk of "joint ventures". A country outflows of FDI means that it is "exporting money" to "buy" or "build" foreign productive capacity, whose ownership will remain in the first country's hands. For a country, attracting an inflow of FDI strengthen the connection to world trade networks and finance its development path. However, unilateral massive FDI to a country can make it dependent on the external pressure that foreign owners might exert on it. Since it is through FDI that a firm becomes a multinational, one could say that it's the FDI process that generates MNC (multinational companies). The reverse is also true: firms that are already multinational generate the majority of FDI flows. 1.2. Composition FDI has three components: Equity capital;
An Overview of FDI
reinvested earnings, the investor's share of earning not distributed as dividends by affiliates, in proportion to its share in the equity (say for instance 50% in a certain joint venture); Intra-company loans, when the investor borrows funds to the affiliate, usually without the intention of asking the money back.
1.3. Determinants At investor's level, a firm can decide to make a foreign investment because of many factors, including: Upstream integration, by purchasing a provider, whose input will now be sold cheaper (or exclusively) to it or be differentiated along particular features; Horizontal integration, by purchasing a firm making the same product, to expand its production, reduces costs, improving logistics; Downstream integration, by purchasing a firm using or distributing its products, to get higher value added along the chain and to aggressively push distribution; Diversification, by purchasing a firm doing somewhat different activities than the purchaser, to seize new opportunities. 1.4. Classification of Foreign Direct Investments There is no single definition that applies to all types of FDI, and TNCs certainly do not label their activities in this way. Instead, it is principally the academic community that has set out to define the varieties of FDI. One view breaks foreign investment into four distinct types: resource seeking, market seeking, efficiency seeking, and strategic asset seeking. Having a clear understanding of the investor's motivation helps you to target more effectively particular varieties of investors for your location. 1.5. Classification by Motivation Resource seeking FDI in natural resources (minerals, raw materials, and agricultural products) FDI seeking low-cost or specialized labor
An Overview of FDI
Market Seeking FDI into markets previously served by exports, or into closed markets protected by high import FDI by supplier companies following their customers overseas FDI that aims to adapt products to local tastes and needs, and to use local resources Efficiency seeking Rationalized or integrated operations leading to cross-border product or process specialization Strategic asset seeking Acquisitions and alliances to promote long-term corporate objectives Most FDI in developing and transition economies is resource seeking. This type of investment aims to exploit a country's comparative advantage. For instance, countries rich in primary materials, such as oil or minerals, will attract companies seeking to develop these resources. Low-cost or specialized labor is two other factors that attract resource-seeking FDI. Resource-seeking FDI is generally used to produce goods for export. In contrast, market-seeking investment is aimed at reaching local or regional markets, often including neighboring countries. Companies making this type of investment typically manufacture a wide variety of household consumer products or other types of industrial goods in response to actual or future demand for their products. In some cases, market-seeking FDI occurs as supplier companies follow their customers overseas. For example, an auto components manufacturer may follow a car producer. Market-seeking investment is often defensive and is used by companies to try to circumvent real or threatened import barriers. A liberal trade regime is essential if the investor wishes to serve neighboring or overseas markets. Efficiency-seeking FDI frequently occurs as a follow-on form of investment. A TNC may make a number of resource- or market-seeking investments, and over time, it may decide to consolidate these operations on a product or process basis. Companies are able to do this, however, only if cross-border markets are open
An Overview of FDI
and well developed. As a result, this form of FDI is most common in regionally integrated markets, most notably in Europe and Asia. TNCs also may undertake smaller-scale product rationalization among a few neighboring countries. This type of investment is illustrated by Nestl's North African and Middle Eastern affiliates. Each affiliate produces a specialized product for the regional market. Each affiliate also imports other products from sister affiliates in neighboring countries. Taken together, the region has access to a full spectrum of products, but each affiliate is responsible for the production of only a small segment. Strategic asset-seeking FDI occurs when companies undertake investments, acquisitions or alliances to promote their long-term strategic objectives. For example, a TNC may form a strategic alliance with a company based in another country to jointly undertake mutually beneficial R&D. Strategic asset-seeking FDI is common in industrialized countries. By contrast to the classification according to the institutional sector, the OECD Benchmark definition favors an industrial breakdown, which includes nine economic sectors. The OECD specifically recommends, for the purpose of this classification, that FDI carried out via a resident holding company be classified according to the industrial sector to which the parent company belongs. Under this criterion, when the parent company is a bank, FDI transactions carried out by a non-banking holding company would be attributed to the Banks
An Overview of FDI
Institutional sector (IMF) Monetary Authority Banks General Government Other Resident Sector
Economic or industry sector (OECD) Agriculture, hunting, forestry and fishing Mining and quarrying Manufacturing Electricity, gas and water Construction Wholesale and retail trade and restaurants Transport, storage and communications Financing, real estate and business services Community, social and personal services
The topics touched upon above, will be discussed in detail in coming chapters.
An Overview of FDI
2.
Current Global Scenario and Trends
The year 2011 was a challenging one for the global FDI market. Natural disasters in Asia-Pacific and economic and political instability in Europe, north Africa and the Middle East led many companies to put on hold their FDI plans, leading to a sharp decline in FDI in many countries. North America, with brighter economic prospects and a shale rush, achieved solid FDI growth. Likewise, companies continued to be attracted to the investment opportunities in Africa and Latin America, with 20%-plus growth in FDI in each region. Brazil was again the star performer, with a 38% increase in FDI projects. Renewable energy was the fastest growing sector for FDI in 2011, despite the challenges facing the sector which are discussed in our sector focus. Renewable energy became the leading sector for capital investment in Europe in 2011, and was the second largest sector in North America. The following data uncovers how expansions are becoming a much more important element of the FDI market. In recent times, almost one in five FDI projects was an expansion project, and the data further shows that expansions are particularly important for extraction, manufacturing, and front- and backoffice projects. 2.1. Global Overview (Source: Financial Times)
An Overview of FDI
Against the backdrop of another tumultuous year for the world economy, foreign investors have remained cautiously optimistic with slow but solid growth in FDI. The number of FDI projects increased by 5.6% in 2011, faster than the 3% increase in 2010. In total FDI Markets recorded 13,718 FDI projects in 2011. After declining by 14.5% in 2010, the estimated capital investment associated with FDI projects grew by 1.2% in 2011 to $860bn, indicating the beginning of a recovery in more capital-intensive sectors. The same pattern was seen in employment, with estimated direct job creation from FDI increasing by 2.5% in 2011 to 2.27 million, following a 3.5% decline in 2010. Despite the political upheaval in North Africa, Africa as a whole was the growth hotspot in 2011, with a 24% increase in FDI projects recorded. In contrast, Europe was the only region to experience a decline in the number of FDI projects in 2011. With Europe holding back recovery, the FDI market still has some way to go to reach the pre-recession peak of 15,489 FDI projects.
An Overview of FDI
A big winner for FDI in 2011 was Brazil and its neighbors in Latin America. A longtouted success story, Brazil has been steadily attracting more FDI projects since 2007. Last year was a record year for FDI projects in Brazil, and capital investment also grew by 48%. However, as a source country for FDI, Brazil still accounts for less than 1% of global FDI projects and 0.5% of global capital invested. Brazils neighbors are also benefiting from the growing interest in the region: Argentina Colombia and Uruguay each achieved growth in FDI project numbers in 2011. Overall, the number of FDI projects in Latin America grew by 22% in 2011, just behind the 24% growth in Africa, and accounted for 10% of global FDI projects. India and China also had a strong performance in 2011, achieving an increase in capital investment of 15% and 3%, respectively, as well as an increase in project numbers. Russia experienced a small decrease in FDI project numbers and capital investment, although outward FDI projects from Russia grew marginally by 3%. Ranked sixth in the world as a source of FDI, Canada is growing rapidly in importance as a global investor, establishing 41.9% more projects overseas in 2011 than in 2010. Capital investment from Canadian companies overseas grew even more, by an estimated 59.4% in 2011. Australian companies also ramped up their investment overseas, establishing 20.5% more FDI projects in 2011 than in 2010, with a 52.8% growth in job creation overseas compared to 2010. 2.2. Sector Highlights The top five sectors in terms of project numbers all experienced growth in 2011. Software and IT remained the leading sector for global FDI projects, with a very strong 18% increase in project numbers. The top three sectors, which also include business and financial services, accounted for 34.7% of global FDI projects in 2011. Metals were the leading sector worldwide when ranked by capital investment, with an estimated $111.65bn of FDI in 2011. Metals replaced the coal, oil and natural gas sector in the number one spot a position it had maintained since FDI
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Markets began tracking FDI in 2003. The number of FDI projects in the metals sector grew by 17.8% in 2011. Renewable energy was one of the fastest growing sectors in 2011, with the number of FDI projects increasing by 20% and with capital investment increasing by 40.7%. Renewable energy was the third largest sector for capital investment, after metals and coal, oil and natural gas. The automotive sector also had a good year in 2011, with FDI project numbers growing by 12.8%. Capital investment associated with these projects reached an estimated $63bn in 2011 and job creation accounted for 13% of the global total. China, India and the US attracted more than 38% of these projects. The real estate sector continued to stagnate, with an 11.5% decline in FDI project numbers in 2011, ranking 15th its weakest performance since 2005. Capital investment and jobs also continued to fall in the sector in 2011. Why the market did not recover in 2012? The global economy experienced four major shocks in 2011, which had a negative impact on corporate investment plans. First, the Arab Spring created high levels of political uncertainty and investment risk in several countries in North Africa and subsequently the Middle East. Second, the earthquake, tsunami and nuclear disaster in Japan had a major impact on the Japanese economy and global supply chains. Third, the massive flooding in Thailand, a leading country for FDI, forced many companies to postpone their investment plans in the country and also disrupted global supply chains. Fourth, the European debt crisis added to global risk and uncertainty and reduced economic growth in Europe to near zero. The outcome of these four shocks can be clearly seen in FDI statistics for 2011. FDI Markets recorded a 29% decline in the number of FDI projects investing in Egypt, a 25% decline in Japan, a 35% decline in Thailand and a 22% decline in projects investing in Italy. With production and supply chains severely damaged domestically, Japan and Thailand-based companies accelerated their outward FDI overseas with growth in outward FDI projects in 2011 of 6% and 45%, respectively. 2.3. Regional Highlights Asia Pacific
FDI projects into Asia Pacific: China, India and Singapore attracted 57% of FDI projects in Asia- Pacific in 2011. India was the strongest performing country with a 21% growth in FDI projects in 2011, following just 1% growth in 2010. The impact of the natural disasters in Japan and Thailand is clearly evident in the sharp decline in FDI in both countries. Hong Kong had a strong year, with its number of projects growing by 6%, after a 21% drop in 2010. In terms of the size of projects, Indonesia, Pakistan and South Korea and each recorded growth in capital investment in 2011 of more than 70% after securing large-scale investment projects. Examples include Cyprus-based Solvay Group announcing a $3bn nickel smelting plant in Indonesia, and United Arab Emirates based Al Ghurair Group announcing plans to develop a $700m oil refinery in Pakistan. The top-performing country for attracting new jobs was China, which saw just over 340,000 jobs created as a result of inward FDI. FDI Projects out of Asia Pacific Analyzing FDI overseas, Japan, India and China accounted for more than 60% of FDI projects from Asia-Pacific countries in 2011. Japan remained the dominant outward investor, establishing more FDI projects overseas than India and China combined. Japans position is even more important when the size of projects is considered, with Japanese companies creating nearly 300,000 jobs overseas; 40% of total overseas job creation generated by Asia-Pacific countries.
An Overview of FDI
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This map shows % change from 2011
Of the major investing countries, Hong Kong and Australia recorded the fastest growth in outward FDI projects, with percentage growth rates of 23% and 21%, respectively. In Thailand, flooding over the monsoon season seems to have encouraged domestic companies to invest overseas. In terms of capital investment overseas, Indian, Hong Kong and Vietnamese companies each increased their outward FDI by more than 70% in 2011.
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Capital investment by sector in 2011: Metals and minerals was the largest sector for FDI, with an estimated $46bn of capital investment tracked by FDI Markets in Asia-Pacific in 2011. With a 54% decline in capital investment in coal, oil and natural gas, the sector moved down into second place. In contrast, FDI in renewable energy grew rapidly, with a 59% in project numbers and 77% increase in jobs creation in the sector in 2011. In total, an estimated $6.93bn of FDI was announced in Asia-Pacifics renewable energy sector in 2011. Software and IT services, while not appearing in the top sectors in terms of capital investment, had a strong year in terms of project numbers, with a 27% increase, and in job creation with nearly 60,000 new software and IT services jobs created by FDI in the region in 2011.
Europe FDI projects into Europe: The number of FDI projects in Europe declined by 3% in 2011, with a mixed performance across countries. The UK experienced solid growth in FDI, reinforcing
An Overview of FDI
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its position as the leading FDI location in Europe. As well as a 13% increase in recorded FDI project numbers, capital investment in the UK increased by 48% and FDI job creation by 33%. However, in terms of total job creation, FDI in Russia generated the highest number of new jobs, with 89,047 jobs created in 2011 compared to 66,817 in the UK. This was despite a decline in FDI in Russia in 2011. A selection of small and medium-sized economies in Europe performed strongly. Ireland, the Netherlands, Serbia and Romania all achieved a significant growth in inward FDI. While the Netherlands was the best performer, with 29% growth in FDI projects in 2011, estimated job creation from FDI in the Netherlands actually fell by 13% as the average project size declined. In contrast, job creation in Ireland grew by 13% and capital investment by 78%. Positioned outside the top 10, Belgium was among the countries that experienced a contrast, with a 43% decline in the number of recorded FDI projects in 2011. FDI Projects Out of Europe:
This map shows % change from 2011
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In terms of investment overseas, the UK retained its position as the leading European investor measured by the number of FDI projects established overseas in 2011, closely followed by Germany. German companies, however, created a higher number of jobs overseas, with 180,830 created by German companies in 2011 and 155,987 by UK companies. The number of FDI projects overseas from France and Russia increased slightly in 2011. FDI from Spain created 19% fewer jobs and 28% lower capital investment than in 2010. Ireland and Denmark also saw growth in the number of outward FDI projects by 20% and 21%, respectively. Capital investment made by Danish companies overseas increased from an estimated $3.4bn in 2010 to nearly $8bn in 2011. Major Danish investors included Grundfos, a manufacturer of pipes and pumps, investing in a 50m manufacturing facility in Serbia, and Lego announcing plans to boost capacity at its Nyiregyhaza plant in Hungary with an investment of $94m. The largest sector for FDI in Europe in 2011 was renewable energy. Capital investment in renewable energy almost doubled in 2011, reaching an estimated $40bn and accounting for one-third of estimated capital investment in Europe. In contrast, capital investment in the coal, oil and natural gas sector fell by 36%, with estimated investment of $13bn. The transport equipment sector also saw a large decline in FDI in 2011 with a 25% drop in capital investment.
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North America FDI projects into North America: Four states/provinces attracted 33 % of FDI into North America in 2011. California was the leading state for FDI in North America, attracting 12% of inward FDI projects in 2011, followed by New York (8%), Ontario (7%) and Texas (6%). The fastest growing of the top 15 states/provinces for FDI in 2011 were Alberta, New Jersey, Massachusetts and Pennsylvania. FDI projects out of North America: While California was the leading state in North America for outward FDI, with 629 projects in 2011, of the top 15 outward investors; Ontario recorded the fastest growth in outward FDI in 2011, with a 50% growth in project numbers. Quebec also saw a substantial increase in outward FDI with a 33% increase in FDI projects in 2011. Washington, Georgia, Florida, Texas and New Jersey also all saw strong growth in outward FDI. Capital investment by sector in 2011:
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Coal, oil and natural gas and renewable energy were the top two sectors for FDI in 2011, accounting for 34% of capital investment in North America. The ranking is reversed from 2010, when renewable energy was the leading sector followed by coal, oiling natural gas. Focus on investment opportunities in shale gas and oil is the main factor behind the change in ranking, which saw the sector increase its capital investment in North America by nearly 300% in 2011. Middle East and Africa FDI projects into Middle East and Africa: The number of FDI projects in the Middle East and Africa (MEA) region grew by 16% in 2011. Capital investment was down slightly by 1% and job creation up by 3%. The top 10 countries for FDI attracted 64% of projects and capital investment, and 54% of jobs created. The United Arab Emirates attracted the highest number of projects, while Saudi Arabia attracted the most capital investment, which grew by 40% in 2011 to just over $14bn. However, this is still far below the $42bn in capital investment recorded in Saudi Arabia in 2008. South Africa was the best performing country in the region in 2011, with a 57% increase in project numbers, 87% growth in capital investment, and a 28% rise in jobs created, making it the leading country in the region for job creation. The political turmoil of 2011 led to some dramatic changes in the volume of FDI in the countrys most affected by the Arab Spring uprisings. The number of FDI projects in Libya and Yemen declined by 80%, in Egypt by 29%, in Syria by 26% and in Tunisia the number of FDI projects fell by 14%. FDI projects out of Middle East and Africa: Companies from the MEA region invested in 10% more projects overseas in 2011 than 2010, accounting for 4% of global FDI projects. Despite the growth, the number of overseas FDI projects from MEA companies was still only 71% of the volume recorded in 2008. The growth in projects led to a small increase in capital investment of 0.4% but a decline in the number of jobs created by 6%. UAE based companies remained most active in FDI overseas, although the number of their projects declined by 3% in 2011 and capital investment overseas declined by 43%. This was largely due to continued decline in real estate FDI, with UAE companies investing in 57% fewer real estate projects in 2011 than 2010. South African
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companies were the second most active in investing, with a strong growth of 25% more projects overseas, 93% more capital investment and 65% more job creation in 2011. Capital investment by sector in 2011: Given the vast natural resources of the MEA region, coal, oil and natural gas was the leading sector for FDI, with an estimated $35bn capital investment in 2011. However, capital investment growth declined by 17% during 2011. The second leading sector in 2011 was the metals and minerals sector, with $27bn of investment, a 67% increase on 2010. In terms of project numbers, financial and business services were the top sector, accounting for 33% of all projects recorded in the MEA region, with growth of 3% in 2011. In terms of jobs created, metals and minerals was the leading sector with an estimated 57,000 jobs created and with very strong jobs growth of 38% in 2011. The sector accounted for more than one-quarter of all jobs created by FDI in the MEA region in 2011. The fastest growing sector for FDI in the region was the food, beverages and tobacco sector, with a 49% increase in FDI project numbers, a 140% increase in jobs created, and a 200% increase in capital investment. The weakest performing sector in 2011 was again the real estate, hotels and tourism sector, with a 36% decline in FDI projects and 40% decline in capital investment in 2011.
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2.4. Expansions: A Growing Part of FDI Global trends in expansions: When making an investment decision to develop its operations through organic growth, a company has two main choices: set up a new operation or expand an existing one. Over the period 2004-08, expansions declined in importance from 17% of capital investment in 2004 to just 11% in 2008. This was a period of rapid growth in the FDI market, with many companies establishing their first operations in fast-growing emerging markets. Emerging market companies were also rapidly expanding and building their global footprints. As a result, expansions became relatively less important in global FDI. Since 2008, the start of the global economic crisis, the reverse trend has been seen with expansions becoming more important
for global FDI. In 2011, expansions accounted for 23% of global capital investment from FDI. In the period of global economic crisis, investors have shown a much stronger preference for expanding existing operations than at any time since FDI Markets began collating FDI data in 2003. Expanding existing operations has been seen as a lower-risk and lower-cost FDI strategy than establishing a new presence. Role of expansions for different FDI project types: Expansions were most important for extraction projects, which are very capitalintensive projects requiring substantial re-investment over a period of many years for most projects. Expansions were also very important for manufacturing projects, with 39% of projects in 2011 being expansions. Manufacturing expansions accounted for 10% of all global FDI projects in 2011. Expansions were also of high importance for front and back offices, indicating that many companies have already established their regional or global back- and front-office operations, with future investment decisions often involving expansion of existing operations. The business functions where expansions are least important are construction, electricity, and sales, marketing and support; where up to 95% of FDI involves new investment projects. Importance of expansions by country: The role of expansions varies significantly across countries. Ireland has one of the highest proportions of expansions, as does Hungary. Both countries act as regional hubs for the manufacturing operations of global companies, which typically results in a higher proportion of expansions in FDI. Countries with a long track record in attracting FDI, or with a high level of foreign acquisitions, also resulted in a higher share of expansions. Expansions in the US, the UK, Mexico and Canada accounted for around one-quarter of FDI projects. Countries which are relatively new to FDI and which are rapidly growing tended to have a small share of expansions in FDI. Indonesia, Turkey, Russia and Kenya all have belowaverage levels of expansions in FDI. Low-tax and entry point economies, including Switzerland, UAE, Singapore and Hong Kong, also had a very low proportion of expansion in FDI, most likely due to their attractiveness for new companies due to low tax.
To summarize, the shift of FDI to emerging markets continued to gather pace in 2011, with Africa and Latin America and the Caribbean recording the fastest growth in inward FDI. From a global perspective, FDI is largely market-seeking, which explains why the economic regions with the best economic growth prospects are attracting a larger share of global FDI. This trend is amplified by resource-seeking FDI, with Africa, Latin America and resource-rich countries in Asia attracting more investment. As the case of North America shows, the shift in FDI to economic growth poles and resource-rich countries does not necessarily result in less FDI in the advanced economies; FDI in North America continued to grow in 2011. However, without strong economic growth or natural resources (such as vast shale oil and gas reserves in North America), there are fewer investment opportunities, leading to a decline in FDI. With limited natural resources, Europe is unlikely to achieve growth in FDI without solid economic growth. The FDI forecasting unit at FDI Intelligence is predicting 4.4% growth in global FDI in 2012 as its positive scenario. This assumes that there are no major economic and political crises (for example, a Greek default), that Europe does not fall into recession, and that Chinas economic growth does not slow down below 7.5%. If any of these events take place, then our revised forecast for 2012 is a 1% to 2% growth in FDI. If multiple events take place, then the FDI market is likely to decline in 2012. In the context of market uncertainty and, at best, slow growth in FDI in 2012, the focus on renewable energy and expansions are of particular importance. Renewable energy has become one the largest and fastest growing sectors for FDI. With the right government policies, environmental conditions and industry competitiveness, there continues to be very strong opportunities to attract FDI in this sector. With rapid take-up of cloud-based services, social media and mobile devices, we also expect strong growth of FDI in data centers in 2012, in particular green data centers, which utilize renewable energy for their power requirements.
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3.
Contribution of FDI towards development
Foreign direct investment (FDI) is an integral part of an open and effective international economic system and a major catalyst to development. Yet, the benefits of FDI do not accrue automatically and evenly across countries, sectors and local communities. National policies and the international investment architecture matter for attracting FDI to a larger number of developing countries and for reaping the full benefits of FDI for development. The challenges primarily address host countries, which need to establish a transparent, broad and effective enabling policy environment for investment and to build the human and institutional capacities to implement them. With most FDI flows originating from OECD countries, developed countries can contribute to advancing this agenda. They can facilitate developing countries access to international markets and technology, and ensure policy coherence for development more generally; use overseas development assistance (ODA) to leverage public/private investment projects; encourage non-OECD countries to integrate further into rules-based international frameworks for investment; actively promote the OECD Guidelines for Multinational Enterprises, together with other elements of the OECD Declaration on International Investment; and share with non-members the OECD peer review-based approach to building investment capacity. Developing countries, emerging economies and countries in transition have come increasingly to see FDI as a source of economic development and modernization, income growth and employment. Countries have liberalized their FDI regimes and pursued other policies to attract investment. They have addressed the issue of how best to pursue domestic policies to maximize the benefits of foreign presence in the domestic economy. The study Foreign Direct Investment for Development attempts primarily to shed light on the second issue, by focusing on the overall effect of FDI on macroeconomic growth and other welfare-enhancing processes, and on the channels through which these benefits take effect.
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The overall benefits of FDI for developing country economies are well documented. Given the appropriate host-country policies and a basic level of development, a preponderance of studies shows that FDI triggers technology spillovers, assists human capital formation, contributes to international trade integration, helps create a more competitive business environment and enhances enterprise development. All of these contribute to higher economic growth, which is the most potent tool for alleviating poverty in developing countries. Moreover, beyond the strictly economic benefits, FDI may help improve environmental and social conditions in the host country by, for example, transferring cleaner technologies and leading to more socially responsible corporate policies 3.1. Trends The magnitude of FDI flows continued to set records through the last decade, before falling back in 2001. In 2000, world total inflows reached 1.3 trillion US dollars (USD) or four times the levels of five years earlier. More than 80% of the recipients of these inflows, and more than 90% of the initiators of the outflows, were located in developed countries. The limited share of FDI that goes to developing countries is spread very unevenly, with two-thirds of total FDI flows from OECD members to non-OECD countries going to Asia and Latin America. Within regions there are some strong concentrations on a few countries, such as China and Singapore in the case of Asia. Even so, FDI inflows represent significant sums for many developing countries, several of them recording levels of FDI, relative to the size of the domestic economy, that overshadow the largest OECD economies . Moreover, the flow of FDI to developing countries worldwide currently overshadows official development assistance by a wide margin, further highlighting the need to address the use of FDI as a tool for economic development. OECD FDI Outflows by Region
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In recent years, an increasingly large share of FDI flows has been through mergers and acquisitions (M&A). This partly reflects a flurry of transatlantic corporate takeovers, and partly the large-scale privatization programs that were implemented throughout much of the world in the 1990s. In developing countries, however, Greenfield investment has remained the predominant mode of entry for direct investors, followed by foreign companies participation in privatizations. 3.2. FDI and Growth Beyond the initial macroeconomic stimulus from the actual investment, FDI influences growth by raising total factor productivity and, more generally, the efficiency of resource use in the recipient economy. This works through three channels: the linkages between FDI and foreign trade flows, the spillovers and other externalities vis--vis the host country business sector, and the direct impact on structural factors in the host economy. Most empirical studies conclude that FDI contributes to both factor productivity and income growth in host countries, beyond what domestic investment normally would trigger. It is more difficult, however, to assess the magnitude of this impact, not least because large FDI inflows to developing countries often concur with unusually high growth rates triggered by unrelated factors. Whether, as
sometimes asserted, the positive effects of FDI are mitigated by a partial crowding out of domestic investment is far from clear. Some researchers have found evidence of crowding out, while others conclude that FDI may actually serve to increase domestic investment. Regardless, even where crowding out does take place, the net effect generally remains beneficial, not least as the replacement tends to result in the release of scarce domestic funds for other investment purposes. In the least developed economies, FDI seems to have a somewhat smaller effect on growth, which has been attributed to the presence of threshold externalities. Apparently, developing countries need to have reached a certain level of development in education, technology, infrastructure and health before being able to benefit from a foreign presence in their markets. Imperfect and underdeveloped financial markets may also prevent a country from reaping the full benefits of FDI. Weak financial intermediation hits domestic enterprises much harder than it does multinational enterprises (MNEs). In some cases it may lead to a scarcity of financial resources that precludes them from seizing the business opportunities arising from the foreign presence. Foreign investors participation in physical infrastructure and in the financial sectors (subject to adequate regulatory frameworks) can help on these two grounds. a. Trade and Investment While the empirical evidence of FDIs effects on host-country foreign trade differs significantly across countries and economic sectors, a consensus is nevertheless emerging that the FDI-trade linkage must be seen in a broader context than the direct impact of investment on imports and exports. The main trade-related benefit of FDI for developing countries lies in its longterm contribution to integrating the host economy more closely into the world economy in a process likely to include higher imports as well as exports. In other words, trade and investment are increasingly recognized as mutually reinforcing channels for cross-border activities. However, hostcountry authorities need to consider the short and medium-term impacts of FDI on foreign trade as well, particularly when faced with currentaccount pressures, and they sometimes have to face the question of
whether some of the foreign-owned enterprises transactions with their mother companies could diminish foreign reserves. As countries develop and approach industrialized nation status, inward FDI contributes to their further integration into the global economy by engendering and boosting foreign trade flows (the link between openness to trade and investment is illustrated by figure below). Apparently, several factors are at play. They include the development and strengthening of international networks of related enterprises and an increasing importance of foreign subsidiaries in MNEs strategies for distribution, sales and marketing. In both cases, this leads to an important policy conclusion, namely that a developing countrys ability to attract FDI is influenced significantly by the entrants subsequent access to engage in importing and exporting activities. This, in turn, implies that would-be host countries should consider a policy of openness to international trade as central in their strategies to benefit from FDI, and that, by restricting imports from developing countries, home countries effectively curtail these countries ability to attract foreign direct investment. Host countries could consider a strategy of attracting FDI through raising the size of the relevant market by pursuing policies of regional trade liberalization and integration.
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Host countries ability to use FDI as a means to increase exports in the short and medium term depends on the context. The clearest examples of FDI boosting exports are found where inward investment helps host countries that had been financially constrained make use either of their resource endowment (e.g. foreign investment in mineral extraction) or their geographical location (e.g. investment in some transition economies). Targeted measures to harness the benefits of FDI for integrating host economies more closely into international trade flows, notably by establishing export-processing zones (EPZs), have attracted increasing attention. In many cases they have contributed to a rising of imports as well as exports of developing countries. However, it is not clear whether the benefits to the domestic economy justify drawbacks such as the cost to the public purse of maintaining EPZs or the risks of creating an uneven playing field between domestic and foreign enterprises and of triggering international bidding wars. Recent studies do not support the presumption that lesser developed countries may use inward FDI as a substitute for imports. Rather, FDI tends to lead to an upsurge in imports, which is often gradually reduced as local companies acquire the skills to serve as subcontractors to the entrant MNEs. b. Technology Transfers Economic literature identifies technology transfers as perhaps the most important channel through which foreign corporate presence may produce positive externalities in the host developing economy. MNEs are the developed worlds most important source of corporate research and development (R&D) activity, and they generally possess a higher level of technology than is available in developing countries, so they have the potential to generate considerable technological spillovers. However, whether and to what extent MNEs facilitate such spillovers varies according to context and sectors. Technology transfer and diffusion work via four interrelated channels: vertical linkages with suppliers or purchasers in the host countries;
horizontal linkages with competing or complementary companies in the same industry; migration of skilled labor; and the internationalization of R&D. The evidence of positive spillovers is strongest and most consistent in the case of vertical linkages, in particular, the backward linkages with local suppliers in developing countries. MNEs generally are found to provide technical assistance, training and other information to raise the quality of the suppliers products. Many MNEs assist local suppliers in purchasing raw materials and intermediate goods and in modernizing or upgrading production facilities. Reliable empirical evidence on horizontal spillovers is hard to obtain, because the entry of an MNE into a less developed economy affects the local market structure in ways for which researchers cannot easily control. The relatively few studies on the horizontal dimension of spillovers have found mixed results. One reason for this could be efforts by foreign enterprises to avoid a spillover of knowhow to their immediate competition. Some recent evidence appears to indicate that horizontal spillovers are more important between enterprises operating in unrelated sectors. A proviso relates to the relevance of the technologies transferred. For technology transfer to generate externalities, the technologies need to be relevant to the host-country business sector beyond the company that receives them first. The technological level of the host countrys business sector is of great importance. Evidence suggests that for FDI to have a more positive impact than domestic investment on productivity, the technology gap between domestic enterprises and foreign investors must be relatively limited. Where important differences prevail, or where the absolute technological level in the host country is low, local enterprises are unlikely to be able to absorb foreign technologies transferred via MNEs. c. Human Capital Enhancement The major impact of FDI on human capital in developing countries appears to be indirect, occurring not principally through the efforts of MNEs, but rather from government policies seeking to attract FDI via enhanced human capital. Once individuals are employed by MNE subsidiaries, their human
capital may be enhanced further through training and on-the-job learning. Those subsidiaries may also have a positive influence on human capital enhancement in other enterprises with which they develop links, including suppliers. Such enhancement can have further effects as that labor moves to other firms and as some employees become entrepreneurs. Thus, the issue of human capital development is intimately related with other, broader development issues. Investment in general education and other generic human capital is of the utmost importance in creating an enabling environment for FDI. Achieving a certain minimum level of educational attainment is paramount to a countrys ability both to attract FDI and to maximize the human capital spillovers from foreign enterprise presence. The minimum level differs between industries and according to other characteristics of the host countrys enabling environment; education in itself is unlikely to make a country attractive to foreign direct investors. However, where a significant knowledge gap is allowed to persist between foreign entry and the rest of the host economy, no significant spillovers are likely. Among the other important elements of the enabling environment are the host countrys labor market standards. By taking steps against discrimination and abuse, the authorities bolster employees opportunities to upgrade their human capital, and strengthen their incentives for doing so. Also, a labor market where participants have access to a certain degree of security and social acceptance lends itself more readily to the flexibility that is a key to the success of economic strategies based on human capital. It provides an environment in which MNEs based in OECD countries can more easily operate, applying their home country standards and contributing to human capital development. One strategy to further this goal is a wider adherence to the OECD Declaration on International Investment and Multinational Enterprises, which would further the acceptance of the principles laid down in the Guidelines for Multinational Enterprises. While the benefits of MNE presence for human capital enhancement are commonly accepted, it is equally clear that their magnitude is significantly
smaller than that of general (public) education. The beneficial effects of training provided by FDI can supplement, but not replace, a generic increase in skill levels. The presence of MNEs may, however, provide a useful demonstration effect, as the demand for skilled labor by these enterprises provides host-country authorities with an early indication of what skills are in demand. The challenge for the authorities is to meet this demand in a timely manner while providing education that is of such general usefulness that it does not implicitly favor specific enterprises. Empirical and anecdotal evidence indicates that, while considerable national and sectors discrepancies persist, MNEs tend to provide more training and other upgrading of human capital than do domestic enterprises. However, evidence that the human capital thus created spills over to the rest of the host economy is much weaker. Policies to enhance labor-market flexibility and encourage entrepreneurship, among other strategies, could help buttress such spillovers. Human capital levels and spillovers are closely interrelated with technology transfers. In particular, technologically advanced sectors and host countries are more likely to see human capital spillovers and, conversely, economies with a high human capital component lend themselves more easily to technology spillovers. The implication of this is that efforts to reap the benefits of technology and human capital spillovers could gain effectiveness when policies of technological and educational improvement are undertaken conjointly. d. Competition FDI and the presence of MNEs may exert a significant influence on competition in host-country markets. However, since there is no commonly accepted way of measuring the degree of competition in a given market, few firm conclusions may be drawn from empirical evidence. The presence of foreign enterprises may greatly assist economic development by spurring domestic competition and thereby leading eventually to higher productivity, lower prices and more efficient resource allocation. Conversely, the entry of MNEs also tends to raise the levels of concentration in host-country markets, which can hurt competition. This
risk is exacerbated by any of several factors: if the host country constitutes a separate geographic market, the barriers to entry are high, the host country is small, the entrant has an important international market position, or the host-country competition law framework is weak or weakly enforced. Market concentration worldwide has increased significantly since the early 1990s due to a wave of mergers and acquisitions that has reshaped the global corporate landscape. At the same time, a surge in the number of strategic alliances has changed the way in which formally independent corporate entities interact. Alliances are generally thought to limit direct competition while generating efficiency gains, but evidence of this is not firmly established. There has also been a wave of privatizations that has attracted considerable foreign direct investment (mainly in developing and emerging countries), and this, too, could have important effects on competition. Empirical studies suggest that the effect of FDI on host-country concentration is, if anything, stronger in developing countries than in more mature economies. This could raise the concern that MNE entry into lessdeveloped countries can be anti-competitive. Moreover, while ample evidence shows MNE entry raising productivity levels among host-country incumbents in developed countries, the evidence from developing countries is weaker. Where such spillovers are found, the magnitude and dispersion of their effects are linked positively to prevailing levels of competition. However, the direct impact of rising concentration on competition, if any, appears to vary by sector and host country. There are relatively few industries where global concentration has reached levels causing real concern for competition, especially if relevant markets are global in scope. In addition, high levels of concentration in properly defined markets may not result in reduced competition if barriers to entry and exit are low or buyers are in a good position to protect themselves from higher prices. While it is economically desirable that strongly performing foreign competitors be allowed to replace less productive domestic enterprises,
policies to safeguard a healthy degree of competition must be in place. Arguably the best way of achieving this is by expanding the relevant market by increasing the host economys openness to international trade. In addition, efficiency-enhancing national competition laws and enforcement agencies are advisable to minimize the anti-competitive effects of weaker firms exiting the market. When mergers are being reviewed and when possible abuses of dominance cases are being assessed, the accent should be on protecting competition rather than competitors. Modern competition policy focuses on efficiency and protecting consumers; any other approach may lead to competition policy being reduced to an industrial policy that may fail to deliver long term benefits to consumers. e. Enterprise Development FDI has the potential significantly to spur enterprise development in host countries. The direct impact on the targeted enterprise includes the achievement of synergies within the acquiring MNE, efforts to raise efficiency and reduce costs in the targeted enterprise, and the development of new activities. In addition, efficiency gains may occur in unrelated enterprises through demonstration effects and other spillovers akin to those that lead to technology and human capital spillovers. Available evidence points to a significant improvement in economic efficiency in enterprises acquired by MNEs, albeit to degrees that vary by country and sector. The strongest evidence of improvement is found in industries with economies of scale. Here, the submersion of an individual enterprise into a larger corporate entity generally gives rise to important efficiency gains. Foreign-orchestrated takeovers lead to changes in management and corporate governance. MNEs generally impose their own company policies, internal reporting systems and principles of information disclosure on acquired enterprises (although cases of learning from subsidiaries have also been seen), and a number of foreign managers normally come with the takeover. Insofar as foreign corporate practices are superior to the ones prevailing in the host economy, this may boost corporate efficiency,
empirical studies have found. However, to the extent that country specific competences are an asset for managers in subsidiaries, MNEs need to strive toward an optimal mix of local and foreign management. An important special case relates to foreign participation in the privatization of government-owned enterprises. Experiences, many of them from the transition economies in East and Central Europe, have been largely positive; participation by MNEs in privatizations has consistently improved the efficiency of the acquired enterprises. Some political controversies have, however, occurred because the efficiency gains were often associated with sizeable near term job losses. Moreover, the value of FDI in connection with privatization in transition economies could partly reflect the fact that few domestic strategic investors have access to sufficient finance. In those few cases where domestic private investors were brought into previously publicly owned enterprises, important efficiency gains resulted. The privatization of utilities is often particularly sensitive, as these enterprises often enjoy monopolistic market power, at least within segments of the local economy. The first-best privatization strategy is arguably to link privatization with an opening of markets to greater competition. But where the privatized entity remains largely unreconstructed prior to privatization, local authorities often resort to attracting foreign investors by promising them protection from competition for a designated period. In this case there is a heightened need for strong, independent domestic regulatory oversight. Overall, the picture of the effects of FDI on enterprise restructuring that we can derive from recent experience may be too positive, because investors will have picked their targets among enterprises with a potential for achieving efficiency gains. However, from a policy perspective, this makes little difference, as long as foreign investors differ from domestic investors in their ability or willingness to improve efficiency or realize new business opportunities. Authorities aiming to improve the economic efficiency of their domestic business sectors have incentives to encourage FDI as a vehicle for enterprise restructuring.
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3.3. FDI and environmental and social concerns FDI has the potential to bring social and environmental benefits to host economies through the dissemination of good practices and technologies within MNEs, and through their subsequent spillovers to domestic enterprises. There is a risk, however, that foreign-owned enterprises could use FDI to export production no longer approved in their home countries. In this case, and especially where host-country authorities are keen to attract FDI, there would be a risk of a lowering or a freezing of regulatory standards. In fact, there is little empirical evidence to support the risk scenario. The direct environmental impact of FDI is generally positive, at least where hostcountry environmental policies are adequate. There are, however, examples to the contrary, especially in particular industries and sectors. Most importantly, to reap the full environmental benefits of inward FDI, adequate local capacities are needed, as regards environmental practices and the broader technological capabilities of host-country enterprises. The technologies that are transferred to developing countries in connection with foreign direct investment tend to be more modern, and environmentally cleaner, than what is locally available. Moreover, positive externalities have been observed where local imitation, employment turnover and supply-chain requirements led to more general environmental improvements in the host economy. There have been some instances, however, of MNEs moving equipment deemed environmentally unsuitable in the home country to their affiliates in developing countries. The use of such inferior technology will usually not be in the better interest of a company; this demonstrates the sort of environmental risk associated with FDI. Empirical studies have found little support for the assertion that policy makers efforts to attract FDI may lead to pollution havens or a race to the bottom. The possibility of a regulatory chill, however, is harder to refute forth lack of a counterfactual scenario. Apparently, the cost of environmental compliance is so limited (and the cost to a firms reputation of being seen to try to avoid them so
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great) that most MNEs allocate production to developing countries regardless of these countries environmental regulations. The evidence supporting this argument seems to depend on the wealth and the degree of environmental concern in the MNEs other countries of operation. Empirical evidence of the social consequences of FDI is far from abundant. Overall, however, it supports the notion that foreign investment may help reduce poverty and improve social conditions. The general effects of FDI on growth are essential. Studies have found that higher incomes in developing countries generally benefit the poorest segments of the population proportionately. The beneficial effects of FDI on poverty reduction are potentially stronger when FDI is employed as a tool to develop labor-intensive industries and where it is anchored in the adherence of MNEs to national labor law and internationally accepted labor standards.
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There is little evidence that foreign corporate presence in developing countries leads to a general deterioration of basic social values, such as core labor standards. On the contrary, empirical studies have found a positive relationship between FDI and workers rights. Low labor standards may, in some cases, even act as a deterrent to FDI, due to investors concerns about their reputation elsewhere in the world and their fears of social unrest in the host country. Problems may, however, arise in specific contexts. For example, the non-trivial role that EPZs play in many developing countries could, some have argued, raise concerns regarding the respect for basic social values. 3.4. Net Contribution of FDI to Developments The main policy conclusion that can be drawn from the study is that the economic benefits of FDI are real, but they do not accrue automatically. To reap the maximum benefits from foreign corporate presence a healthy enabling environment for business is paramount, which encourages domestic as well as foreign investment, provides incentives for innovation and improvements of skills and contributes to a competitive corporate climate. The net benefits from FDI do not accrue automatically, and their magnitude differs according to host country and context. The factors that hold back the full benefits of FDI in some developing countries include the level of general education and health, the technological level of host-country enterprises, insufficient openness to trade, and weak competition and inadequate regulatory frameworks. Conversely, a level of technological, educational and infrastructure achievement in a developing country does, other things being equal, equip it better to benefit from a foreign presence in its markets. Yet even countries at levels of economic development that do not lend themselves to positive externalities from foreign presence may benefit from inward FDI through the limited access to international funding. By easing financial restraint, FDI enables host countries to achieve the higher growth rates that generally emanate from a faster pace of gross fixed capital formation. The eventual economic effect of FDI on economies with little other recourse to finance depends crucially on the policies pursued by host-country authorities.
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These sectors composition of an economy can also make a difference. While the service sectors of many developing countries may be underdeveloped and hence unable to attract large inflows of FDI, extractive industries in countries with abundant natural resources can be developed beneficially with the aid of foreign investors. In addition to the potential drawbacks of inward FDI mentioned earlier, some micro-oriented problems could arise. For instance, while the overall impact of FDI on enterprise development and productivity is almost always positive, it generally also brings distributional changes and a need for industrial restructuring in the host economy. Changes give rise to adjustment costs and are resisted by social groups that do not expect to be among the beneficiaries. Structural rigidities in the host economy exacerbate such costs, not least where labor markets are too slow to provide new opportunities for individuals touched by restructuring. Overall, the costs are best mitigated when appropriate practices are pursued toward flexibility, coupled with macroeconomic stability and the implementation of adequate legal and regulatory frameworks. While the responsibility for this lies largely with host-country authorities, home countries, MNEs and international forums also have important roles to play. In cases where domestic legal, competition and environmental frameworks are weak or weakly enforced, the presence of financially strong foreign enterprises may not be sufficient to assist economic development although there are examples (notably in finance) where the entry of MNEs based in OECD member countries has contributed to an upgrading of industry standards. Where economic and legal structures create a healthy environment for business, the entry of strong foreign corporate contenders tends to stimulate the host-country business sector, whether through competition, vertical linkages or demonstration effects. FDI can be said to act as a catalyst for underlying strengths and weaknesses in the host countries corporate environments, possibly exacerbating the problems in no governance zones, while eliciting the advantages in countries with a more benign business climate and better governance. This reinforces the point made above about the need for host (and home) countries to work to improve
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regulatory and legal frameworks and other elements that help enable the business sector. Finally, FDI like official development aid cannot be the main source for solving poor countries development problems. With average inward FDI stocks representing around 15 % of gross domestic capital formation in developing countries, foreign investment acts as a valuable supplement to domestically provided fixed capital rather than a primary source of finance. Countries incapable of raising funds for investment locally are unlikely beneficiaries of FDI. Likewise, while FDI may contribute significantly to human capital formation, the transfer of state-of-the-art technologies, enterprise restructuring and increased competition, it is the host country authorities that must undertake basic efforts to raise education levels, invest in infrastructure and improve the health of domestic business sectors. Domestic subsidiaries of MNEs have the potential to supplement such efforts, and foreign or international agencies may assist, for example through measures to build capacity. But the benign effects of FDI remain contingent upon timely and appropriate policy action by the relevant national authorities.
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4.
Political Considerations
Do political risks discourage Foreign Direct Investment (FDI) in both developing and developed economies in a similar manner? In this chapter, we examine whether and in what manner political risks affect FDI and compare its different effects in developing and developed economies. Using the 12 category Political Risk Index compiled by the International Country Risk Guide (ICRG), we find the following: First, political risk is a significant determinant of FDI in both industrialized and developing nations. Second, not all aspects of political risk affect FDI stocks in industrialized and developing countries in the same way. When we compare the effects of different political risk component, we find that since the 9/11 attacks, political risks have become more important and significant determinants of FDI flows, especially in industrialized nations. Do political risks discourage Foreign Direct Investment (FDI) in both developing and developed economies in a similar manner? Which particular aspect of political riskspolitical, societal, and economic risks at the domestic level and international problemsaffect FDI flows and stocks more significantly in developing and developed countries? Already fierce competition for FDI among nations has become more intense due to the recent global economic downturn. Many economic determinants of FDI a large domestic market , sustainable growth , sufficient economic and infrastructure development or high natural resources endowmentare beyond the control of government. Stable political and policy environments are also attractive investment determinants. Host countries can turn domestic economies into more attractive investment environments by reducing political risk and promoting stable and liberal policy to attract more foreign investment, although these are long-term changes. Thus, the goal of this paper is to provide a microscopic look at the effect of individual political risk components on FDI in both developed and developing markets. This, we believe, will provide a blueprint for long-term policy directions to shape a friendlier and favorable investment environment: what works and what doesnt when it comes to attracting FDI. Our paper will inform policy makers on which particular aspect of political risk has significant effect on attracting FDI and provide an outline on
the long-term political and institutional development favorable for attracting more foreign investors. As the literature on the determinants of FDI informs, political and institutional risk is one of the major concerns for foreign investors, especially in developing nations. Some political risks, e.g., a resurgence of resource nationalism and unfavorable annulment or change of the terms of foreign investment, continue to pose a great challenge to foreign investors in developing markets. In addition, recent high profile and massive casualty terrorist attacks not only stress the prevalence of political violence and the importance of political risk as a challenge to foreign investors, but also highlight that even developed countries are not immune to political risk and violence. A question, thus, arises, how does political risk affect FDI flows in developed nations in the face of such a volatile political environment? How does a high profile incident of political violence affect how political risk shapes FDI flows and stocks? Let us examine whether and in what manner political risk affects FDI and compare its different effects in developing and developed economies. We also examine how political risk affects FDI since the 9/11 attacks, especially in developed nations, as we deem that the 9/11 attacks marked a watershed moment. The attacks were catastrophic events that shaped not only world politics but also the global economy dramatically. They had devastating effects on global FDI flows and stocks shortly after, although Enders et al. (2006) do not find any significant lasting effects of the 9/11 attacks on the global economy. Thus, we divide our analysis into before and after the 9/11 and compare the effects of political risk between these two different periods. We find the following: First, political risk is a significant determinant of FDI in both industrialized and developing nations. Second, not all aspects of political risk affect FDI stocks in industrialized and developing countries in the same way. A host economy with good democratic accountability (DEMO) and a good investment profile (INVT) can attract significantly more FDI in both industrialized and developing countries. On one hand, other political risk components, such as ethnic tensions (ETHC) and military in politics (MLTY), significantly impact FDI in industrialized countries, but they do not have significant effects on FDI in developing nations. On the other hand, in
developing nations, markets with better law and order (Law), low religious tension (RLGN), and more stable government (GORN) tend to attract more FDI. Third, since the 9/11 attacks, political risks have become more important and significant determinants of FDI flows, especially in industrialized nations. Since the 9/11 attacks, democratic accountability (DEMO), investment profile (INVM), and military in politics (MLTY) have significant positive effects on FDI, while ethnic tensions (ETHC) has a significant negative effect on FDI stocks. Considerations to political risk to FDI are threefold: first, we investigate and compare the effects of political risks by using a larger and more comprehensive sample than previous studies, and our analysis includes both developing and developed nations over the period of 1984-2003; second, we investigate how high-profile and catastrophic terrorist attacks, especially the 9/11 attacks in the US, shape the importance of political risk as a determinant of FDI in industrialized countries afterwards; third, we use a more complete and comprehensive measure of political risk to better understand how each aspect of political risk affects FDI stocks in both developing and developed nations. We use a 12 category Political Risk Index compiled by the International Country Risk Guide (ICRG) to investigate the individual effect of each political risk component on FDI in both developing and industrialized countries. 4.1. Literature Review FDI is a driving force behind the economic growth of a host economy and the rapid economic globalization of the global economy1: To a hosting economy, FDI is an engine of employment, technological progress, productivity improvements and ultimately economic growth and a mechanism of technology transfer between countries, particularly to the less-developed nations. Thus, many nations, although at times ambivalent about the political and social impact of foreign investors and even somewhat fearful of dependency created by FDI, have adopted increasingly more liberal trade and economic policies and have been seeking to attract more FDI over time, especially since the 1990s Capital-poor developing nations engage in various FDI-related policy changes to attract foreign investors. They liberalize FDI-related policies, offer tax and other
financial incentives to foreign investors, and/or join international and regional organizations and bilateral treaties as a mechanism to signal a liberal commitment to foreign investors. To better compete against other potential FDI host countries, developing nations, at times, offer short-term, upfront subsidies to foreign investors. Janeba (2002), however, argues that upfront subsidies may not work. Host nations with low credibility do not necessarily offer as high subsidies as they could offer to attract foreign investment, knowing that MNCs can move investment to another high-cost but high-credibility market when faced with unfavorable investment circumstances in developing economies. Thus, the problem of the lack of credible commitment exists in both MNCs and host markets and "upfront subsidies are not sufficient to fully overcome lack of commitment. Even when developing markets offer subsidies to overcome the lack of credibility and compensate for potential sunk cost losses, this might not be sufficient to win over MNCs and their investments. These subsidies and incentives are popular policies to attract more FDI into host economies, but they are politically and economically costly and controversial. Li (2006) argues that "FDI promotion programs often instigate rent-seeking behaviors in host countries where governments directly pick winners and losers in the market, discriminate against small and local firms, and *these+ incentives help MNCs strengthen their competitiveness and their ability to monopolize the host market". Thus, Li (2006) recommends the following to attract more FDI: The more cost-effective strategy to attract foreign capital is by building and strengthening the governance institutions in a country and by improving the investment environment (p. 72). Examining the determinants of FDI in Africa, Asiedu (2006) recommends a similar solution as Li (2006) does: FDI inflow is not solely determined by certain exogenous factors, i.e., natural resources and large markets, but small countries without these location advantages can still attract FDI by improving their institutions and policy environment. 4.2. Discouragement by Political Risk to FDI There are multiple factors that attract or deter foreign investment. Simply put, market opportunities and location advantages of the host economy help host
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economies attract more FDI: Such advantages include a large domestic market, sustainable growth, sufficient economic and infrastructure development and/or high natural resources endowment. Bad investment and policy environments in host economies deter FDI. Political instability and violenceboth domestic and internationaldiscourage MNCs from investing in the host economy that is subject to such risk. A host economy with high political risk tends to discourage FDI flows into its market, since political volatility hurts the profitability of foreign investment. Three major types of political risk discourage foreign investment since they damage its profitability and survival: first, nationalization or expropriation of foreign assets, which tends to be rare, and breach of contract, which occurs more often, threaten foreign investment; second, policy instability and arbitrary regulation in FDI-related policies create uncertain investment environments and hurt the profitability of foreign investments; and, third, war and political violence, including terrorist activities, can damage foreign assets immediately and discourage the productivity of a host economy in the long run. One of the most extreme cases of political risk is nationalization and expropriation of foreign assets. Although nationalization of foreign assets has become rare even in developing nations since the 1990s, such a possibility still exists. For example, Chvez nationalized the last privately owned oil reserve in Venezuela in 2007, heightening tension with other foreign investors, such as BP PLC, ConocoPhillips, Exxon Mobil Corp., Chevron Corp., France's Total SA and Norway's Statoil ASA. The real threat, however, Ramarmurti and Doh (2004) argue, is administrative expropriation, which has become more frequent. The host government can squeeze and hurt the profit of foreign investment by denying and delaying the development of investment and, thus, forcing foreign investors to renegotiate and change the terms of investment. Consequently, reducing the risk of nationalization helps host countries attract more FDI. For example, host countries can attract more FDI when they implement strong property rights and implement policies reducing expropriation risk. Among the host countries of US FDI, strengthening property rights has a strong positive
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effect on FDI inflows. Examining the effects of economic reforms in Latin American countries, scholars find that not all countries that implemented economic reforms were necessarily able to attract more FDI. Only countries that implemented both economic reforms and reduced expropriation risks were able to draw more FDI from foreign investors. For example, Indonesia was one of the most successful FDI hosting countries in Asia in the 1970s, largely due to its probusiness and pro-FDI policy measures. Such measures include the 1967 Foreign Investment Law that prohibited the government from nationalizing foreign investment. Thus, reducing expropriation risk is a key in securing more FDI, especially in developing nations. The quality of institutionspolitical, legal , policy and investmentinfluences FDI inflows and stock in host countries. A sound business environment largely depends on the quality of governmental institutions, and, thus, good governance is an attractive location advantage for foreign investors. First, a sound regulation and legal environment is essential for host countries to attract FDI. Host countries with an adequatenot too restrictive but not too insufficientregulation environment are able to attract more FDI and reap the benefit of FDI and achieve economic growth more effectively. Using the ICRG measure of political risk, scholars also show that a stable legal system and low corruption have a positive effect on FDI inflows. Second, a sound investment environment, e.g., a more streamlined policy process and removal of arbitrary treatment of foreign investors, also promotes FDI inflows. Examining the effects of investment agreements on FDI, Berger et al. show that host countries receive more FDI when they agree to treat foreign and national investors equally by removing discrimination or arbitrary treatment and providing a more stable investment environment to foreign investors. For example, Double Tax Treaties (DTTs) remove the double-taxation of foreign-earned income and make it easier for foreign investors to maximize profits from foreign investment. DDTs, thus, help host countries attract more FDI. Political violence, e.g., civil wars, insurrections, organized crimes and international conflicts, leads to political instability, the disruption of the orderly economic process in the host country, and thus smaller profit, and such events may put
host governments under political and economic pressure, which may result in nationalization and expropriation of foreign assets in order to alleviate short-term difficulties. First, international conflict deters FDI shows that the onset of fatal conflicts not only tends to reduce FDI stock with a delay of three years but FDI inflows, in turn, also decrease the war risk of host countries. Second, domestic instability and violence can also deter FDI. Ethnic tension and religious tension deter foreign investment. The recent study on Italy shows that organized crime is strongly and negatively correlated with FDI inflows since organized crime tends to limit corporations business activities and profitability through corruption and violence. Others find that MNCs weigh both the global, overall political risk of host countries measured by the ICRG, and diplomatic, dyadic political tension between a host country and the US when they make foreign investment. They increase the required return rate of investment as the overall political risk of a host country, measured by the ICRG, increases and diplomatic tension between the host country and the US worsens. Thus, host countries hoping to attract more FDI should avoid conflict and violence at home and abroad. Political Risk in Developing Countries and Changing Political Environment: Foreign investors who expand into a foreign market, thus, have to worry about political risk of the host economy, since political volatility and violence may damage the investment, diminish the efficiency of overall market and, thus, hurt the profitability or survival of their investment. Political risk is an important determinant of foreign investors location decisions, also due to the nature of FDI. FDI, while mobile ex ante, is relatively illiquid ex post. For example, when affected by unfair trade policies, exporting MNCs can easily deflectmove their goodsto other markets. However, when protectionist pressure, for example, leads to an unfair policy change that hurts the profitability of foreign investment, MNCs cannot simply move out from the host market. The sunk cost of FDI makes it extremely costly for foreign investors to withdraw investments they have already made in the host market. Knowing that, the host country can exploit or expropriate foreign assets, although they initially promised fair and favorable terms and policies to foreign investors to attract FDI. Foreign investors, thus, have to maximize the profitability of investment by taking advantage of the lower
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factor-costs and location advantages of the host economy but, at the same time, weigh the dangers and potential losses incurred by investing in politically unstable countries. Political risk, thus, is one of the major constraints on foreign investors who seek to expand into foreign markets. Time-inconsistency problemchanging FDI-related policies to less favorable to foreign investors, and, thus, violating the initial terms of foreign investmentcan occur in both developing and advanced economies. However, developing nations often suffer from the shortage of capital and resources, and they have an even greater incentive than governments in advanced industrialized countries to change the terms of existing foreign investment. This is based on the data collected by the World Bank, in Latin America since the late 1980s, 40% of all concessions were renegotiated, with the average time for renegotiation being only 2.2 years. According to the UNCTAD, 10 per cent of all FDI-related regulatory changes were less favorable for foreign investors in 2003 and by 2007 it was 25 per cent, and even before the recession in 2008 in Latin America, as much as 60 per cent of policy measures taken in 2007 were less favorable to FDI (UNCTAD, 2009, p. 41). Political instability and abrupt policy changes can handicap the productivity and profitability of foreign investment. According to the survey of the Multilateral Investment Guarantee Agency (MIGA), foreign investors from both industrialized and developing nations chose political risks as one of the biggest challenges they face in developing and emerging markets.4 Political risk is one of the most important challenges to MNCs, especially when they expand their business into developing nations, since many developing nations with lower factor costs tend to be the markets with higher risks in comparison to other more developed. Foreign investors, thus, encounter a trade-off between investing in a low-cost and low-credibility country and a high-cost and high-credibility country in making investment choices. It is no surprise that the research on FDI has studied the effects of political risk on FDI flows in developing and emerging. The current research has done in developing and emerging markets, not in industrialized economies; and, second, thus, MNCs take political risk as a major consideration of investment location
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decisions in developing economies, but not, or to a lesser degree, in industrialized economies. While we do not argue against this conventional wisdom, we argue that political risk has become an increasingly important determinant even in developed and industrialized countries, as the recent high profile terrorist attacks and violence in these developed and industrialized countries show. High profile and high casualty terrorist attackssuch as the 9/11 attacks in the U.S., the Madrid train bombings, and the 7/7 London bombingshow that industrialized countries are not necessarily immune to volatile and even dangerous political circumstances.5 It is even more so, since these high profile attacks tend to target developed countries more than developing nations. For example, among the top ten countries that suffered the most international terrorist attacks from 1968 to 2006, six were advanced industrialized countries. These dramatic events appear to evince, what Diamante et al. called, a global convergence in political risk. They observe that emerging markets have become politically safer and developed markets have become riskier. Has a convergence in political risk taken place? In this paper, we, thus, examine whether such convergence in political risk has occurred since then. To better understand how catastrophic events like the 9/11 attacks influence FDI flow and stock, we split industrialized samples into two periods of timebefore and after the 9/11 attacks. We examine whether such an explosive incident affects how political risks affect FDI flows and compare how the effects of political risks on FDI flows have changed before and after the 9/11 attacks. Terrorist attacks have grave impacts on economy by depressing growth, investment, and trade flows. Immediately, they cause a loss of human and nonhuman capital, uncertainties, and retrenchment of certain industries like travel and recreation industries. In the long run, they increase "uncertainties of any permanent threat of terrorism" and cause "added anxiety, stress, and mental disorder". Terrorist attacks can further damage attacked countries by discouraging foreign investment flows into the countries. However, some find little to no lasting effects of terrorist attacks on FDI flows.
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Some argue that terrorism deters FDI. Examining the impact of terrorist attacks in LDCs, Economists warn that there are multiple negative impacts of terrorist attacks on the host economy. They argue that foreign investors tend to avoid investing in countries that are subject to frequent terrorist attacks, and, thus, terrorism discourages FDI inflows and has a significant negative effect on *economic+ growth, employment and technological advancement. For example, Enders and Sandler show that intense terrorism activities led to a 13.5 percent net FDI reduction in Spain and an 11.9 percent decrease in Greece during the 1970s. However, this negative effect of terrorism on FDI inflows and stocks appears to be more damaging in low-income and less developed nations. Examining the impact of terrorism on FDI in Asia for 1970-2004, Gaibulloev and Sandler show that poorer and developing countries were less able to absorb the negative impact of terrorism than rich countries. Literature argues that it is because rich and more developed countries have dominant location advantages and, thus, they are better able to diversity foreign investment and appeal to other foreign investors. In addition, Lee shows that the negative impact of terrorism is mitigated by a strong military and, thus, terrorism can deter FDI in a host country only when strong military is absent. Some scholars, however, find moderate to no impact of terrorism on FDI. Investigating the impact of the 9/11 attacks, Enders et al. show that the 9/11 attacks had little long-term effects on U.S. and are not likely to influence the current and future U.S. FDI stocks. Terrorist attacks on U.S. interests have a small, but significant, effect only on the OECD countries and no significant effects on non-OECD countries. US investors were less likely to invest in the OECD countries where they were subject to terrorist violence with casualties. However, they also note that the impacts were smalllowering the stock of U.S. FDI in these countries by only 1 percent for their entire sample period. Although the direct impact of terrorism is beyond the scope of this analysis, we split the sample into two periodsbefore and after the 9/11 attacks to investigate how this high casualty event affects how much political risk plays a role as a determinant of FDI. Here we use the political risk scores measured by the ICRG. This political risk score is advantageous in three regards: First, it gauges a broad and relevant range of
political and economic environments of host countries. Second, it covers a large sample of countries for a long time-period. Third, it is directly relevant for foreign equity investors to the extent that MNCs use this measure. The ICRG measure provides a broad range of political and economic conditions that shape the overall risks and costs of doing business in host countries. Its measure is not limited to one aspect of doing business in host countries, but it is more comprehensive, dealing with twelve aspects of business risks, encompassing political, financial, and economic risks, such as government stability, internal and external conflict, democratic accountability, corruption, and military involvement in politics in addition to socioeconomic conditions and investment profile. This also allows researchers to disaggregate the source of political risk, yielding useful policy implications by pointing to a political risk factor that shapes investors decisions. This analysis encompasses 116 countries (22 industrialized countries and 94 developing countries) during the period of 1984 and 2008. In addition, the ICRG measure is commercially available to and used by foreign investors, and, thus, "clearly relevant for the effects of institutions and government regulations" to the extent it is used by these investors. It is believed that this 12-category political risk index is a more complete and direct measure of political risks involving foreign investment. Thus, we use the ICRG scores to dissect and investigate how different political risk aspects have differential effects on the international investment choices of multinational corporations. Democratic accountability is positively associated with FDI. A higher degree of constraint on the executive body in democratic countries helps attract more FDI, since it discourages arbitrary FDI related policies. Democratic accountability also helps reduce economic volatility, thus providing a more stable business environment for foreign investors. Although there are some similar results, the differences in the effects of political risks on FDI are quite salient. Ethnic tensions (ETHC) and military in politics (MLTY) significantly impact FDI in industrialized countries, but they do not have significant effects on FDI in developing nations. Less military in politics is found to attract FDI in industrialized countries. Some may question this finding by pointing out the US and the UK, two major countries that account for about 45% of total
FDI inflow to industrialized economies, are also the two biggest military spenders in the world. Admittedly, the US and the UK are the two biggest FDI recipients and military spenders; however, the MLTY variable measures not only military spending, but more importantly, it accounts for the dominance of military involvement in politics, which, in the case of the US and the UK, is not large. Indeed, if we compare the US and the UK with other industrialized nations, the scores in military in politics index (MLTY) have only a tiny difference (5.75 versus 5.67). While the result for military in politics is in line with the conventional wisdom, the ethnic tensions result is quite interesting. We find that an industrialized country with higher ethnic tension attracts more FDI. A probable cause may be that the US and the UK, where there are more ethnic problems than in other industrialized nations, while, at the same time, these two nations receive a majority of FDI to industrialized countries. On the other hand, certain political risks affect FDI in developing countries, but not in industrialized economies. For example, better political environments, such as a high amount of government stability (GORN), better law and order (Law), and less religious tensions (RLGN), help developing countries bring in more FDI. This may be because government, law and order, and religious harmony are the three most significant factors that affect the overall stability, including political and economic stability, of a developing country. This in turn ultimately affects foreign investors decisions to invest in FDI. Whereas in industrialized nations, drastic government changes and religious tensions are rare; even if there is a government change, the transition is usually smooth and peaceful. Besides more intuitive findings on GORN, Law, and RLGN, we find some counterintuitive results in our estimate. While we expect the same sign for bureaucracy quality (BUQ), corruption (CRPT), and socioeconomic conditions (SOCL), which is not surprising as all these three indexes are highly correlated with each other; we find a negative sign. In other words, a better condition in BUQ, CRPT, and SOCL deters FDI in developing nations. This is quite interesting and worthy of further investigation. Intuitively, a better condition in BUQ, CRPT, and SOCL welcomes FDI inflows as suggested by some. However, some MNCs that seek low entry barriers and to avoid competition from other foreign investors, may turn to some
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developing countries where bureaucracy quality is low and, thus, corruption is high. In such countries, FDI may get in easily by bribery and face less competition from other MNCs, since few other MNCs tends to go to such corrupt countries. Indeed, according to Fung et al (2009), Chinas FDI tends to go to destinations with poor labor quality where the bureaucracy quality is bad and the corruption level is high. Besides the different effects of political risks on the inflow of FDI in industrialized and developing countries, another finding is noteworthy. As we discussed in section 1, the MNCs in industrialized countries have experienced an abrupt change after the 9/11 attacks in 2001. We wonder whether the 9/11 attacks fundamentally changed how MNCs make international investment decisions, namely becoming more perceptive and cautious about the political risks in industrialized countries. Our conjecture is that the 9/11 attacks, one of the worst terrorist attacks in history, may not only amend world politics, but also alter investors perception of political risks in a subtle way. To test our speculation that FDI behavior differed before and after the 9/11 attacks, we split our industrialized countries data sample into two samples, covering the period before and after the 9/11 attacks, and run an empirical regression. We locate the report of results before and after the 9/11 attacks in column IDC-1 and IDC-2, respectively. Before interpreting our results, we have to clarify that, in the current study, we are not trying to find out why and how the 9/11 attacks changed the FDI behaviors. Rather, we simply study what has changed after the 9/11 attacks in terms of how political risks affect FDI in industrialized countries. When interpreting the data, we temporary ignore the control variables, such as GDP, OPN, and so on, as they have an expected result, and solely focus on the political risk. Before the 9/11 attacks, among the 12 political risks, only external conflicts (XTNC) is estimated to be significant. This is what we expected using the conventional wisdom that political risks rarely matter for FDI in industrialized countries, since industrialized countries are deemed to be politically stable and immune to radical political changes and violence. The only significant risks (XTNC) marked by a negative coefficient are again accounted for by two major FDI
recipients, the US and the UK, which have been involved in multiple foreign conflicts. Even with wars involved, FDI still flows to the US and the UK; aside from that, they are fundamentally sound for FDI. However, after the 9/11 attacks, the situation has a significant change. According to our results in column IDC-2, four out of the 12 political risks are significant and the external conflict is dwarfed by these four risks and becomes insignificant. Among these four significant risks, democratic accountability (DEMO), investment profile (INVM), and military in politics (MLTY) garner an expected positive sign, while ethnic tensions (ETHC) gets a negative sign. To avoid the risk of repetition, we refer readers to the fifth paragraph of this section for the interpretation of results. This shows that the 9/11 attacks had a lasting effect on FDI in an indirect manner. Although Enders finds that the 9/11 attacks had little enduring effects on FDI, especially among the OECD countries, our study shows that since the 9/11 attacks, political risk has become a more significant determinant of a host market's ability to maintain FDI stock in developed countries. Most interestingly, since the 9/11 attacks in developed markets, certain political risk factors become significant factors for determining FDI stocks, although they were not before the 9/11 attacks: Since the 9/11 attacks, democratic accountability (DEMO), investment profile (INVM), and military in politics (MLTY) have significant positive effects on FDI, while ethnic tensions (ETHC) has a significant negative effect on FDI stocks. This shows that the 9/11 attacks may not have direct and lasting effects on FDI, but some political risk components have become significant determinants of FDI stocks afterwards, especially in developed countries. Thus, the 9/11 attacks may have had an unexpected, long-term consequence in that they highlighted the importance of political risk in determining foreign investors' decisions to continue FDI in a host market in developed markets. Thus, the 9/11 attacks may not have a direct, long-term negative effect on FDI flows and stocks, but they might have changed the way FDI is distributed in developed markets. In summary, by studying the 12 individual components of the political risk, we find that FDI responds to the different political risks in different ways in industrialized and developing countries. The 9/11 attacks have changed the behavior of FDI in industrialized countries with regards to political risks. There is,
interestingly, only one political risk, internal conflicts (INTC), that seems to not matter at all for FDI in both industrialized and developing countries. We find that political risks are important considerations for foreign investors even in industrialized markets when we control for other economic factors: first, Political risk is a significant determinant of the flow of FDI in both industrialized and developing nations; second, not all political risk components affect the inflow of FDI in the same fashion in industrialized and developing countries in a similar manner; and, third, Since the 9/11 attacks, political risks have become more significant determinants of FDI especially in industrialized nations. Estimates suggest that a host economy with good democratic accountability (DEMO) and a good investment profile (INVT) can attract significantly more FDI in both industrialized and developing countries. On one hand, other political risk components, such as ethnic tensions (ETHC) and military in politics (MLTY), significantly impact FDI in industrialized countries, but they do not have significant effects on FDI in developing nations. On the other hand, in developing nations, markets with better law and order (Law), low religious tension (RLGN), and more stable government (GORN) tend to attract more FDI. This may be because government stability, law and order, and religious harmony are the three most significant factors that affect the overall stability, including political and economic stability, of a developing country.
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5.
Social Considerations
Multinational enterprises (MNEs) have become one of the key drivers of the world economy and their importance continues to grow around the world. The increased influence of OECD-based MNEs in developing countries is particularly striking. Today, developing countries account for almost one-third of the global stock of inward foreign direct investment (FDI), compared to slightly more than one fifth in 1990. The increased role of FDI in developing and emerging economies has raised expectations about its potential contribution to their development. FDI can bring significant benefits by creating high-quality jobs and introducing modern production and management practices. And many governments have developed policies to further promote inward FDI. However, the activities of multinational enterprises abroad have also aroused much controversy and social concerns. For example, MNEs have been accused of practicing unfair competition when taking advantage of low wages and labor standards abroad. In some cases, MNEs have also been accused of violating human and labor rights in developing countries where governments fail to enforce such rights effectively. In many OECD countries, civil society has appealed to MNEs to ensure that internationally-recognized labor norms are respected throughout their foreign operations. This chapter presents the main insights from OECD work on the social impact of inward FDI in host countries. It looks at how much MNEs contribute to better working conditions in host countries and what governments, in both home and host countries, can do to promote good work practices by MNEs. The questions which are considered for discussion are: How important is FDI for developing countries? How does FDI affect workers? Are working conditions in MNE better than local firms? How does FDI affect the wider economy?
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How can governments ensure that FDI boosts development?
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How important is FDI for developing countries? During the past 15 years, the importance of FDI in the world economy has increased rapidly. The total stock of FDI increased from 8% of world GDP in 1990 to 26% in 2006. Although the bulk of FDI continues to take place between OECD countries, the increase in FDI has been particularly pronounced in developing countries, largely reflecting the integration of large emerging economies, the socalled BRICs (Brazil, Russia, India and China), into the world economy. The increase of FDI into developing countries has been spectacular. The share of non-OECD countries in the global stock of inward FDI has risen from 22% in 1990 to 32% in 2005 (see Figure 1). China is by far the most important non-OECD country as a recipient of FDI, accounting for about one third of FDI in non-OECD countries in 2005. However, FDI inflows also tend to be sizable in many other emerging countries. Indeed, since the mid-1990s, inward FDI has become the main source of external finance for developing countries and is more than twice as large as official development aid. Developing countries have also become increasingly active as foreign direct investors themselves. The share of non-OECD countries in the global stock of outward FDI has risen from 10% in 1990 to 17% in 2005. The rise in outward FDI in emerging economies reflects predominantly the increase in FDI between nonOECD countries (South-South FDI). Outward FDI by emerging economies into the OECD remains relatively small, despite recurrent claims in the popular media that developing countries are acquiring strategic assets in OECD countries. How does FDI affect workers?
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MNEs tend to have various advantages compared to purely domestic firms that allow them to compete successfully in foreign markets, despite the additional cost of having to coordinate activities across different countries. They may derive this advantage from their technological know-how, easier access to capital or modern management practices. The potential benefits of inward FDI depend on the extent to which local firms and workers can benefit from these assets. One way that FDI can be beneficial for host economies is by creating high-quality jobs that are associated with higher pay and better working conditions. While there is no reason, in general, to expect MNEs to offer better jobs than their local counterparts, under certain circumstances, MNEs may find it in their interest to share their productivity advantage with their employees. For example, MNEs may wish to rely more heavily on pay incentives to ensure quality and productivity, given the higher cost of monitoring production activities from abroad. MNEs may also offer above-market wages in an effort to reduce worker turnover and minimize the risk of their productivity advantage spilling over to competing firms. FDI by OECD-based MNEs may also affect the quality of jobs available in domestic firms when there are knowledge spillovers from foreign to domestic firms. For example, domestic firms may learn from foreign firms by collaborating with them
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in the supply chain. Knowledge transfers may also result from worker mobility, when domestic firms recruit workers with experience in foreign firms. Finally, increased product-market competition as a result of FDI may strengthen incentives among domestic firms to improve their efficiency. However, FDI does not necessarily have positive effects on the performance of local firms. Under certain circumstances, it may lead to the crowding out of local firms, reducing their ability to operate at an economically efficient scale. Are working conditions in MNEs better than in local firms? According to the conventional wisdom, foreign MNEs offer better pay than their local counterparts and foreign-domestic pay differences are particularly important in the context of developing countries. The difference in pay offered by domestic firms and MNEs may reflect the greater technology gap between foreign MNEs and local firms in less developed countries. This view is based on a substantial body of research using information on cross-border takeovers to identify the effect of foreign ownership on average wages within firms. Recent OECD work, however, suggests a rather more complex picture.
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Above figure presents new OECD evidence on the effects of foreign takeovers on average wages for two emerging economies (Brazil and Indonesia) and three OECD countries (Germany, Portugal and the United Kingdom). It shows that foreign takeovers raise average wages within firms in the short-term, particularly in emerging economies. Wages are estimated to grow between 10% and 20% following foreign takeovers in Brazil and Indonesia, and between 0% and 10% in the three OECD countries. However, as these figures show the effect on average wages, it is impossible to tell how the change is distributed across the workforce and, particularly, whether the increase in average wages reflects wage gains for incumbent workers or instead changes in the skill composition of the workforce. To the extent that foreign takeovers lead to skill upgrading, the evidence overestimates the positive effects of takeovers on individual wages.
This next figure presents new OECD evidence on the effects of foreign ownership by focusing directly on individual workers. Foreign takeovers of domestic firms
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have a small positive effect on the wages of existing workers in Brazil, Germany and Portugal in the short-term, ranging from 1% to 4% and no effect in the UK. The absence of a positive effect in the United Kingdom may reflect the relative flexibility of the UK labor market compared to the other countries, which makes it hard to sustain differences in pay for identical workers across firms. While the short-term impact of takeovers on incumbent workers is modest, the role of foreign ownership is more substantial for new hires. This is indicated by the relatively large wage gains of workers who move from domestic to foreign firms. They range from 6% in the United Kingdom to 8% in Germany, 14% in Portugal and 21% in Brazil. In sum, the new evidence confirms that FDI may have a substantial positive effect on wages in foreign-owned firms in the host country, even when the focus is on the short-term impact of cross-border mergers and acquisitions. And consistent with the conventional wisdom, the positive wage effects are more pronounced in emerging economies. Furthermore, the positive impact of FDI resides primarily in better job opportunities for new employees, rather than better pay for workers who stay in firms that happen to change ownership. This may reflect more competitive conditions in the market for new hires that allow new employees to more widely share the productivity advantages of MNEs. In the longer term, however, one would expect the positive effects to spread across the entire workforce, as large pay disparities between new and old workers within firms are unlikely to be sustainable. The question whether MNEs also promote improvements in other aspects of workers employment conditions, such as training, working hours and job stability, is more complex and the existing evidence is scarce. Studies that have looked into this issue suggest that MNEs have a low propensity to export nonwage working conditions abroad. New analysis by the OECD suggests that, in contrast to wages, non-wage working conditions do not necessarily improve following a foreign takeover. Even when they do, it is not clear whether these effects derive from a centralized policy to maintain high labor standards or merely reflect the optimal responses by MNEs to local conditions.
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How does FDI affect the wider economy? In addition to having direct effects on workers employed by MNEs, FDI may also have indirect effects on workers employment conditions in domestic firms when there are knowledge spillovers associated with FDI. The effect on workers in domestic firms, however, is considerably weaker than the direct effect on employees of foreign affiliates of MNEs. It is true that FDI typically has a strong effect on average wages in local firms, but this largely reflects the competition among foreign and domestic firms for local workers. In principle, FDI could also affect wages in local firms through its impact on the productivity in those firms. Positive productivity-driven wage spillovers are likely to be more important when there are strong links between local firms and foreign MNEs, such as through the participation of local firms in the supply chain or through worker mobility. New OECD evidence indicates that average wages are a little higher in local firms which participate in these supply chains or recruit managers with prior experience in MNEs, than in local firms with no apparent link to MNEs. Do the potential benefits of FDI for workers also help to improve the performance of the labor market as a whole? This question is more difficult to address. First, it depends on whether FDI increases labor market inequality or labor market segmentation. The previous literature suggests that inward FDI may contribute to higher earnings inequality, particularly in developing countries, by raising the relative earnings of skilled workers. However, there is little evidence to suggest that FDI leads to an expansion of the informal sector or non-compliance with labor standards. The effects of FDI on the performance of the labor market as a whole also depend on its effects on overall efficiency. The positive wage effects of inward FDI may be a prima facie indication of its impact on productivity resulting from the transfer of modern production and management practices. The bottomline may be that the overall effects of inward FDI on the host country are positive, but that the benefits are not evenly spread over the host-country population. How can governments ensure that FDI boosts development?
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The positive effects of inward FDI for workers in host economies suggest that FDIfriendly policies could be a useful component of an integrated policy framework for development. When designing policies to promote FDI, policy-makers should take into account that these may not only affect the volume of inward FDI, but also its composition and, as a result, its corresponding benefits. The OECD Policy Framework for Investment provides a useful starting point. For a start, removing specific regulatory obstacles to inward FDI could be important. Under certain circumstances, it may also be appropriate to provide specific incentives to potential foreign investors. However, such targeted policies should not become a substitute for policies aimed at improving the business environment more generally. By contrast, lowering core labor standards in an effort to provide a more competitive environment for potential investors is likely to be counterproductive. It does not appear to be effective in attracting FDI and is likely to discourage investment from responsible MNEs, for whom it is important to ensure that minimum labor standards are respected throughout their operations. FDI-friendly policies in host countries can be usefully complemented by multilateral initiatives that seek to enhance the social benefits of inward FDI by promoting responsible business conduct amongst MNEs. The OECD Guidelines for Multinational Enterprises provide a good example of a government-backed initiative that aims to promote responsible business conduct. The Guidelines are most widely known for their system of National Contact Points (NCPs) through which disputes between relevant stakeholders with respect to the implementation of the guidelines can be addressed. Since its revision in 2000, more than 160 cases have been raised at the NCPs. Most of these have dealt with employment, labor and industrial-relations issues. The increasing share of these cases related to labor issues in non-OECD countries suggests that the OECD Guidelines are playing a growing role in the improvement of labor conditions worldwide. There is also an important role for public initiatives that are specifically designed to raise labor practices in the supply chain. For example, by generating greater
transparency in labor practices, improved public monitoring can strengthen the incentives for responsible business conduct among supplier firms. To enhance the attractiveness of their products to responsible buyers, technical assistance and credit facilities may be required to help supplier firms overcome obstacles to improved labor practices in the production process. The Better Work Program, a joint initiative launched by the International Finance Corporation (a member of the World Bank Group) and the International Labor Organization in 2006, is a promising initiative that attempts to raise working conditions in the workplaces of supply-chain factories through the enhanced public monitoring of labor practices and the provision of technical assistance and credit facilities to program participants.
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6.
Challenges
Foreign direct investment (FDI) can play a significant role in host economies' development process. In addition to capital inflows, FDI can be a vehicle for obtaining foreign technology, knowledge, managerial skills and other important inputs; integrating into international marketing, distribution and production networks; and improving the international competitiveness of firms and the economic performance of countries. At the same time, neither inflows of FDI nor the benefits from such inflows are automatic. Governments need to consider what role they want inward FDI to play in their economies' development process, and then design their FDI policies accordingly. Thus, the broad policy objectives are to attract in particular investment that is in line with the identified development objectives; to maximize the potential benefits of FDI; and to minimize negative effects (e.g. balance-of-payments problems, crowding out, transfer pricing, abuse of market power, labor issues and environmental effects). Government intervention (by host or home countries) may be motivated by two primary types of market failures: information or coordination failures in the investment process; and the divergence of private interests of investors (foreign and/or domestic) from the economic and social interests of host economies. To optimize the impact of inward FDI (UNCTAD, 1999), Governments need to address the following four sets of issues: Information and coordination failures in the international investment process; Infant industry considerations in the development of local enterprises, which can be jeopardized if inward FDI crowds out those enterprises; The static nature of advantages transferred by transnational corporations (TNCs) in situations where domestic capabilities are low and do not improve over time, or where TNCs fail to invest sufficiently in improving the relevant capabilities (an issue that is particularly relevant in the context of linkages between foreign affiliates and local firms);
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Host country Governments' weak bargaining and regulatory capabilities, which can result in an unfavorable distribution of benefits from the perspective of society (e.g. negative effects on competition or the environment). In general, developing countries and economies in transition differ from developed countries with regard to the role and impact of FDI in their economies. First, the former are typically net importers of FDI, whereas developed countries in most cases present a more balanced pattern of inward and outward flows of FDI.1 Thus, in the context of FDI and international investment agreements (IIAs), the primary focus for most developing countries and economies in transition is on issues related to their ability to attract inward FDI and benefit from it. In contrast, questions related to improving access to foreign markets for outward investment are of secondary importance, at least for the vast majority of developing countries. Second, the technological gap between domestic and foreign enterprises is generally more accentuated in developing countries and economies in transition. On the one hand, this suggests that these economies should be particularly interested in attracting FDI that can bring much-needed capital, technology and knowledge. On the other hand, weak domestic capabilities hamper the ability to fully reap the benefits of inward FDI. Similarly, whereas inward FDI in countries with relatively unproductive domestic enterprises may provide valuable examples of desirable practices, leading to a rise in productivity, it may also risk crowding out domestic players and may encourage anti-competitive behavior resulting in welfare losses. International agreements in general involve binding commitments, which may lead to the convergence of national policies and can limit the policy autonomy of the parties to an agreement. It is therefore important for developing countries to deepen their understanding of what policies and policy tools are most important from a development perspective; how international rules in the area of investment would affect them; and what commitments can be sought from home countries to support their development objectives. The overall question is how
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IIAs can help developing countries and economies in transition to attract FDI, while allowing sufficient policy space for those countries to regulate in the interest of benefiting as much as possible from such investment. 6.1. Host country policy measures Host countries have various policy tools at their disposal to enhance the developmental impact of FDI. Some are of a general nature and aim at enhancing the attractiveness of the business environment (policies aimed at creating political and macro-economic stability and improving infrastructure and human resources; trade policy; science and technology policies; labor laws, etc.). Such policies can be nationwide or specific to sectors or regions. Another set of policies is geared to the development of enterprise capabilities, especially small and medium-sized enterprises (SMEs). Finally, there are policies that consist of rules and regulations governing the entry and operations of foreign investors, the standards of treatment accorded to them and the functioning of the markets in which they are active (UNCTAD, 1996a). While this note concentrates on the last set of policies since it is most directly related to FDI it is clear that such policies need to be well integrated into the overall development strategy of a country. Countries are scaling up their efforts to attract FDI. This can be seen from the ongoing liberalization of FDI policies involving the opening up of sectors and industries (UNCTAD, 2002). Countries at all levels of development are also continuing to enter into bilateral investment treaties (BITs) and double taxation treaties (DTTs). At the close of 2001, a total of 2,099 BITs and 2,185 DTTs had been concluded (UNCTAD, 2002). While the general trend is in the direction of FDI liberalization, simply opening up an economy is often no longer enough to attract sustained flows of FDI and to ensure that FDI brings the expected developmental benefits. TNCs investment decisions are primarily driven by economic fundamentals (such as market size, the costs and efficiency of production, the quality of infrastructure and access to skills). In response to growing competition for FDI, and to overcome information failures, more and more countries are actively promoting their locations to potential investors. In addition, countries are increasingly adopting a more targeted approach to FDI promotion. Such an
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approach, while not without risk, has been found to increase the chances of attracting the type of investment that can advance a countrys development objectives. In the absence of an enabling policy environment, TNCs tend to focus on the existing comparative advantages of host countries, especially low labor costs and logistical considerations, when locating their export-oriented activities in developing countries. Capitalizing fully on static benefits and transforming them into dynamic and sustainable advantages therefore require proactive government intervention. The development of domestic skills and enterprise capabilities is particularly important for attracting quality FDI and ensuring that the necessary absorptive capacity is present so that full benefit can be derived from knowledge transfers. In terms of the core FDI policies, host countries have implemented, or are implementing, various host country operational measures (HCOMs) that aim at influencing the operation of foreign affiliates inside their jurisdictions (UNCTAD, 2001a). HCOMs can cover all aspects of investment (ownership and control, hiring of personnel, procurement of inputs, etc.) and usually take the form of either restrictions or performance requirements. They are often adopted in order to influence the location and character of FDI and, in particular, to increase its benefits. HCOMs can be divided into three categories (table 1): red-light HCOMs, which are explicitly prohibited by the WTO Agreement on Trade-Related Investment Measures (TRIMs) because of their distorting effect on international trade; yellow-light HCOMs, which are explicitly prohibited, conditioned or discouraged by interregional, regional or bilateral (but not by multilateral) agreements; and green-light HCOMs, which are not subject to control through any IIAs.
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At the multilateral level, the TRIMs Agreement prohibits not only TRIMs that are mandatory in nature but also those that are linked to the receipt of an advantage. It applies only to investment measures related to trade in goods and not trade in services. While such measures frequently arise in the context of foreign investment policies, the Agreement applies equally to measures imposed on domestic enterprises. For example, a local content requirement imposed in a nondiscriminatory manner on domestic and foreign enterprises is inconsistent with the TRIMs Agreement because it involves discriminatory treatment of imported products in favor of domestic products. Some regional agreements also address these and additional performance requirements. The North American Free Trade Agreement (NAFTA), for example, forbids local equity requirements (Art. 1102(4)). Article 1106(1) proscribes the
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imposition or enforcement of mandatory requirements and the enforcement of any undertakings or commitments to (a) export a given level or percentage of goods or services; (b) achieve a given level or percentage of domestic content; (c) purchase, use or accord a preference to goods produced or services provided in the territory of a party or to purchase goods or services from persons in its territory; (d) relate the volume or value of imports to the volume or value of exports or to the amount of foreign exchange inflows associated with investment; (e) restrict sales of goods or services produced or provided by an investment in a partys territory by relating such sales to the volume or value of exports or foreign exchange earnings of the investment; (f) transfer technology, a production process or other proprietary knowledge; or (g) act as the exclusive supplier of the goods produced or services provided by an investment to a specific region or world market The usefulness of various performance requirements remains an area in need of more research. While some studies question the effectiveness of performance requirements, others argue that current IIAs go too far in curtailing the ability of host Governments to improve the quality of FDI in line with their development objectives.4 As regards future negotiation of IIAs, there may be a need for further assessments of the impact of existing agreements at the bilateral, regional and multilateral levels on the use and impact of performance requirements. To avoid deterring FDI, performance requirements have normally been tied to some kind of advantage, often in the form of incentives. Most developed countries offer location incentive packages to both domestic and international investors. Developing countries also offer tax breaks and location packages to attract foreign investors. However, their packages are much smaller, and these countries typically rely relatively more on fiscal measures, whereas financial incentives are more common in developed countries. In developing countries, incentives have been used particularly to attract export-oriented FDI, often in the context of export processing zones (EPZs). In the light of restrictions under the WTO Agreement on Subsidies and Countervailing Measures (the SCM Agreement), developing country WTO members (other than those mentioned in Annex VII of the SCM Agreement and with the exception of those that obtain an
extension of the transition period) will have to eliminate export subsidies (related to goods), as required under the SCM Agreement, by 1 January 2003. Even those obtaining an extension of the transition period cannot increase the level of their export subsidies, are subject to the prohibition with respect to particular products if they achieve export competitiveness in such products, and will need to consider what to do once the transition period expires. At the same time, it is worth reflecting on the legal regime for developmentrelated subsidies. For instance, subsidies to foreign affiliates and/or domestic firms that engage in linkage development activities in developing countries, involving the provision of technology, technical assistance and training to local suppliers and their personnel, may be an important policy tool. A case could be made for, under specified conditions, making certain types of such development oriented subsidies to foreign affiliates non-actionable under WTO rules. Incentives and performance requirements have been used generally in combination with other policy measures to optimize the impact of FDI. In countries in which such measures have played a role in efforts to promote inward FDI, they have typically complemented a range of other measures such as those aimed at enhancing the level of skills, technology and infrastructure. If the business environment is not made more conducive to investment, upgrading and linkages, the risk increases that investors will leave once an incentive expires. Partly as a result of the liberalization of regulations governing the entry of foreign investors, regulatory policies to ensure the smooth functioning of markets become more important. They may involve the adoption of competition rules, merger reviews, environmental laws and stricter financial accounting standards. For many developing countries and economies in transition, the transition from more interventionist policy approaches (at the point of FDI entry) to the regulation of markets is difficult because of a lack of financial and human resources. 6.2. Home country policy measures Host country policies can be supported by home country measures (HCMs). Home countries influence FDI flows in various ways, including the likelihood that
their TNCs will select certain locations.5 The overriding question in this section is therefore how HCMs, in the context of IIAs, can help developing countries and economies in transition to attract and benefit from FDI. This is of particular relevance given the discrepancy between developed and developing countries in terms of the balance between inward and outward FDI. Developed countries have removed most national restrictions on outward FDI, but policy declarations aimed at encouraging outward FDI are seldom linked to any specific commitments in IIAs (UNCTAD, 2001c). Most assistance remains at the discretion of each developed country and is commonly shaped to serve a home countrys own business interests along with general development objectives. This home country perspective is especially evident in the design of many financial or fiscal assistance programs as well as preferential market access measures. The weak link between the explicit needs of developing countries and the design and execution of HCMs, as well as the often uncertain commitment to the duration of assistance, may diminish the beneficial impact that such programs can have on development. Relevant HCMs can, for example, Aim at improving the economic fundamentals of host countries for example, through developing human resources, building institutional capacity and assisting in the design and implementation of adequate framework conditions in relevant policy areas Help to reduce the types of information failures in the investment process alluded to above by assisting in the dissemination of investment opportunities in developing countries and economies in transition Improve market access and facilitate export flows from developing countries Provide investment guarantees and insurance Provide risk and venture capital Support linkage promotion programs Commit to transfers of technology.
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Most developed countries (and a number of other countries) engage in some of these activities, albeit largely on an autonomous basis and in a rather uncoordinated fashion. (For example, there are at least 12 European development finance institutions providing long-term financing for private-sector development in developing and transition economies) Other institutions providing financial assistance at the international level include the World Bank Group, regional multilateral development banks, the Commonwealth Private Investment Initiative and various privately sponsored investment funds 6.3. The right to regulate International agreements, like other legal texts, are specifications of legal obligations, which as such limit the sovereign autonomy of the parties. As international legal obligations generally prevail over domestic rules, a tension is created between the will to cooperate at the international level through binding rules and the need for Governments to discharge their domestic regulatory functions.12 Such tension is generally captured by the notion of the right to regulate, which is central to the question of preserving the national policy space for Governments to pursue their development objectives There are various ways to address the issue of the right to regulate. Some of these, with regard to both trade and investment agreements are reviewed below. In all cases the ability of signatories to regulate the domestic economy is a governing concern. Insofar as this concept is restated in an agreement for instance, in its preamble language it also serves an interpretive function vis-vis the provisions of the agreement. Furthermore, whenever countries enter into standard-of-treatment obligations, such as fair and equitable treatment, prohibition of arbitrary and discriminatory measures or most-favored-nation treatment (MFN) and national treatment, various kinds of exceptions, reservations, derogations, waivers or transitional arrangements ensure that signatories retain their prerogative to apply non-conforming domestic regulations in certain areas. These can be general (e.g. for public order or national security), subject-specific (e.g. the cultural exception) or countryspecific
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Various safeguards are also used to preserve the right to regulate, as in the case of transfer-of-payments and balance-of payments safeguards. Furthermore, time-bound safeguards are often allowed as a measure to enable a country to safeguard its domestic production against a surge of imports. It is necessary to examine to what extent such a concept of safeguards could also be used in the area of investment. The issue of the right to regulate has been dealt with largely in international agreements on trade, and useful concepts and approaches that have been defined in this context have also been used in the context of IIAs. In the area of trade, the issue has been debated and litigated at length in the GATT/WTO system, where the dispute settlement process has been frequently used to police domestic regulatory measures that have an impact on trade. The main instrument for policing regulatory activities in the WTO comes from the 1947 GATT and is found in Article IIIs non-discrimination (national treatment) obligation as complemented by the exceptions contained in Article XX. The general national treatment rule contained in Article III provides that internal taxes and regulations must not treat imports less favorably than domestic products. If a domestic regulatory measure is found to discriminate against imports, the regulating Government may attempt to justify the discrimination by proving that it is necessary in order to achieve some legitimate purpose. Article XX of GATT defines these exceptions to include those necessary to protect public morals; those necessary to protect human, animal and plant life or health; and those relating to the conservation of exhaustible resources. It should be noted that this list of policies that can justify measures otherwise considered in violation of national treatment is closed and thus provides limited scope for claiming an exception in many areas where countries may want to pursue regulatory action. The WTO Agreement on Technical Barriers to Trade explicitly calls for an integrated examination of the purpose of the measures in question and its traderestricting effects. The Agreement clearly requires a balancing of the degree of
trade restriction against the regulatory purpose of the disputed measure. Furthermore, the analysis of the regulatory aim is part of the review of the legality of the measure itself, with an illustrative (not closed) list of legitimate objectives. In this context, there is no need to first establish a violation (which requires a conclusive determination of likeness), followed by a review of the regulatory justification by way of exception. The balancing analysis also calls for an appreciation of the trade effects in the light of existing less restrictive alternatives and of the risk of non- fulfillment of the regulatory objectives. The services sector is highly regulated in many countries for the purpose of consumer protection, security, protection of public morals and prudential measures. While the GATS recognize the sovereign right of a country to regulate services for legitimate purposes, Article VI seeks to prevent the use of administrative decisions to disguise protectionist measures. Generally applied measures that affect trade in service sectors for which a country has made commitments must be applied reasonably, objectively and impartially. Applications to supply services under such commitments must receive a decision within a reasonable period of time. The Council for Trade in Services is called on to develop rules to prevent requirements governing qualifications for service suppliers, technical standards or licensing from being unnecessary barriers to trade. Until such multilateral rules are ready, Governments are to follow (in sectors in which they have undertaken specific commitments) the same principles in applying their requirements and standards, so that these do not nullify or impair specific commitments (on market access and national treatment) they have made. Issues related to the right to regulate first arose in the context of investment protection agreements, with regard to the issues of expropriation and nationalization. Some regional agreements and virtually all bilateral investment treaties include broad language covering measures tantamount or equivalent to expropriation. Hence, they can also apply the expropriation provisions to indirect expropriations or regulatory takings, namely when a host country takes an action that substantially impairs the value of an investment without
necessarily assuming ownership of the investment. Furthermore, a number of BITs and regional investment agreements are also understood to apply the expropriation provision to creeping expropriations that is, expropriations carried out by a series of legitimate regulatory acts over a period of time, whose ultimate effect is to destroy substantially the value of an investment. They generally impose certain conditions on expropriation if it is to be considered lawful, by adopting some variation of the traditional rule of international law that a State may not expropriate the property of an alien except for a public purpose, in a non-discriminatory manner, in accordance with due process of law and upon payment of compensation. Concerns have been expressed with regard to the impact that an expansive use of expropriation claims may have on sovereign Governments right to regulate. In the context of the NAFTA, the three member countries in 2001 adopted some Notes of Interpretation of Certain Provisions of the investment chapter to clarify the provision governing the minimum standard of treatment to be accorded to foreign investors. They determined that the NAFTAs standard is the customary international law minimum standard of treatment. In conclusion, while international rules obviously imply a measure of restriction on domestic regulatory autonomy, several techniques have been used to strike the right balance. The GATT, the Agreement on Technical Barriers to Trade (the TBT Agreement) and the GATS all use different approaches and may provide useful reference models for any future rule- making in the area of investment. With regard to both regional and bilateral IIAs, it is necessary to examine to what extent the right to regulate goes beyond regulatory takings and similar issues of investment protection to encompass the way in which other areas covered in IIAs can be reconciled with the necessary preservation of policy space for development.
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7.
Corporate Social Responsibility and FDI
This chapter focuses on the issue of corporate social responsibility (CSR) in relation to foreign direct investment (FDI), and asks whether CSR expectations should be addressed within an international investment agreement (IIA) at the World Trade Organization (WTO). CSR has been defined as containing three substantive elements; economic development, sustainability and human rights. It is possible to consider human rights and the environmental protection part of sustainability to be about curbing abuses of social and environmental standards. Economic development and the rest of sustainability (medium to long-term patterns of development that are environmentally and socially sustainable) are about promoting positive actions conducive to development. Christian Aid believes that TNCs can play a positive role in development through, for example, technology and knowledge transfer, job creation, higher wages and labor standards, and through the introduction of newer, cleaner technologies to protect the environment. A vibrant private sector is a vital component to longterm development. However, Christian Aid has become concerned that many of the successful policies that have been used in the past to capture the positive development benefits of FDI are becoming unavailable to host countries. Furthermore, as an organization working with poor and vulnerable communities in 60 countries worldwide Christian Aid is very aware of how TNCs can also harm lives and livelihoods by causing damage to the environment, operating to low labor standards and by direct, or complicit, abuse of human rights. There are three key factors related to FDI and MNCs that contribute to this situation: 7.1. Legal limitations on corporate accountability
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Despite national regulations, MNCs can be structured internationally in such a way as to make liability hard to identify, and redress nearly impossible to pursue. Furthermore, TNCs are not direct actors in international law making universally agreed human rights standards, for example, binding on States but not corporations. 7.2. Power imbalances MNCs are increasingly powerful actors in development. Where they represent a significant source of FDI, or where a State is in competition with other States to attract FDI, pressure can be brought to bear on social and environmental standards, driving them downwards, or at best, keeping low standards low, and weak enforcement weak. This also makes it hard to introduce or maintain host country measures designed to capture development gains from FDI.
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7.3. FDI liberalization Rigid investment agreements, including bilateral investment agreements (BITs) and the WTOs trade-related investment measures (TRIMS) agreement, are also making tried and tested host country measures such as performance requirements unavailable to developing countries. This also makes it hard to capture development gains from FDI. 7.4. CSR recommendations In the light of the insufficiency of voluntary approaches, Christian Aid is calling for the establishment of international, legally binding regulation of TNCs to set minimum human rights and environmental standards. This would require an international agreement, which could be in the form of a convention that developed legally binding direct and indirect obligations on TNCs. It would primarily seek to support action at the national level by removing the downward pressure on standards and enabling developing country Governments to develop, implement and enforce higher standards. With the indirect approach the obligation is on the State to enforce human rights and environmental standards that is, indirectly applied to TNCs through the State. This would require a State to sign up to the convention. With the direct approach the obligations are applied directly to the company. National legislation and institutions would be the primary way of implementing these minimum standards. However, in the case of direct obligations, a company could be held to account even if the State within which it was operating had not signed up to the convention. National legislation would recognize countries as both home and host States, and provide the facility to hold the activities of TNCs and their subsidiaries in host countries to account in home countries where appropriate. One way of addressing this would be to develop a presumption of liability between parent and affiliate. This would seek to establish the principle that a parent company is responsible for the actions of its subsidiary unless it can prove the contrary. In these way parent companies that export dirty technologies or that engages with
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repressive regimes can be held properly accountable under the laws of the country in which the decisions were made usually the parents home country. However, if it can be shown that the relevant decisions were made elsewhere, and then liability, properly, should be with the decision makers and not the parent company. Finally, if developing countries are going to be able to capture the developmental benefits of FDI, international investment agreements need to contain greater policy flexibility and autonomy so that host country measures that have been successful in the past can be used by developing countries.To sum it up, the discussion started by defining CSR as having three primary elements; economic development, sustainability and human rights. In seeking to address these three areas I have argued that regulatory responses are required in order to curb environmental and social abuses, whilst greater policy autonomy is required if developing countries are going to gain from FDI in terms of long-term development. This does not preclude voluntary initiatives that go above and beyond societys minimum expectations. However, in the absence of effective regulation such voluntary CSR mechanisms are insufficient to ensure that TNCs play a positive role in development. This paper also argues that regulation must be developed at the international level if developing country Governments are going to be empowered to implement and enforce national- level regulation. However, the call for international responses to the need for higher standards should not be met by initiatives at the WTO. The WTO is neither mandated to take on this work, nor does it have the necessary competencies. The UN is the only appropriate body that could legitimately forward work on the development of an international framework on corporate accountability. Furthermore, if developing countries are to capture the long-term development benefits of FDI, IIAs need to contain greater policy flexibility. Of course, this does not mean that future flexible investment agreements should not contain corporate accountability dimensions. But these agreements would be
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expected to reference international agreements on corporate accountability, housed within the United Nations.
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8.
Conclusion
In light of the findings reached during the course of the analysis, there are some questions which need to be answered, specific to the social, political and economic conditions of the region where the FDI policies are, either already being implemented or the implementation is under considerations. Following are some of these questions. Any new policy being introduced is usually a trade of between giving up on some of the current benefits and reaping new ones. What are these trades off parameters, which should be specific to the regional conditions? Does the regulatory authority allowing direct investments have a roadmap of policies it wants to implements and goals it wants to achieve by doing so? How does the regulatory authority ensure that all the segments of the society which are being directly or indirectly impacted by FDI policies, get sufficient delegations in the decision making process? How do we derive the key performance index which are necessary to measure the effectiveness of the policies being implemented? In case it is observed that the current FDI policies do no succeed in achieving desired effects, what is the process followed to review the current framework and make amendments to it, if required? What is the estimated time required for FDI policies to bring about the expected improvements? Any FDI movement being implemented without considering these factors would be an incomplete one. Hence it is very important to have definite answers to these questions which defining the framework.
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9.
Recommendations
It should be recommended that FDI plays an important role in growth of the country. As India is yet to become a superpower in the world, FDI is mostly used globally and many other countries have looked upon the significance of FDI in many a different aspects (including India). FDI has its own advantages and its disadvantages which should be looked upon quite carefully regarding the necessity of the country whether it is developed, developing and underdeveloped countries. It grooms the business level aspect at a very fast improving rate and develops it very stably. The impact of FDI, to a country would be a great solution in improving the standard of living of the country. It can also tackle the different aspects of the country in terms of finance. It creates a huge impact on the financial system of the country. It may tend to have a slow gradual effect on the economy of the country. So as there are many advantages of FDI, so also there would be disadvantages also. Many of the countries say that foreign investment is done for profitable basis by the foreign investors to get an opportunity to invest in Indian markets. Foreign investment is competitive with home investment, profits in domestic industries fall, leading to fall in domestic savings. Contribution of foreign firms to public revenue through corporate taxes is comparatively less because of liberal tax concessions, investment planning difficult. This increases the perceived risk of making investments and therefore adversely affects the inflow of FDI. The transition to a market economy entails the establishment of a legal and regulatory framework that is compatible with private sector activities and the operation of foreign owned companies. The relevant areas in this field include protection of property rights, ability to repatriate profits, and a free market for currency exchange. It is important that these rules and their administrative procedures are transparent and easily comprehensive. Many of the countries are still debating on the advantages and disadvantages of Foreign Investments, but many of them still suggest that FDI is an important aspect for the country. However, the Government of India has now come upon a decision to implement the role of FDI in Indian markets. So FDI should be firstly analyzed properly and then should be implemented in the country.
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10.
Bibliography
THE DEVELOPMENT DIMENSION OF FDI: POLICY AND RULE-MAKING
PERSPECTIVES, Proceedings of the UN Expert Meeting held in Geneva in Nov 2002 The fDi Report 2012, Financial Times Business The Social Impact of Foreign Direct Investments,OECD Policy Brief, July 2008 An Analysis on Political Risks and the Flow of Foreign Direct Investment in Developing and Industrialized Economies by KyeonghiBaek, Asst Professor, SUNY FDI Policy Instruments: Advantages and Disadvantages, UNITED NATIONS INDUSTRIAL DEVELOPMENT ORGANIZATION
An Overview of FDI
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An Overview of FDI

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T.Y.

BMS Project Report on AN OVERVIEW OF FDI

SUBMITTED BY, CHIRAG NARESH CHAUDHARY T.Y.BMS [Semester V]

SUBMITTED TO, UNIVERSITY OF MUMBAI ACADEMIC YEAR 2012-2013

PROJECT GUIDENCE BY PROF. SRIDHARAN SIR

Signature of Student [CHIRAG CHAUDHARY]

COURSE COORDINATOR (CHANDRAKALA SHRIVASTAVA)

PRINCIPAL (DR AJAY BHAMARE)

Signature of Student [CHIRAG NARESH CHAUDHARY]

By: Chirag Chaudhary

Current Global Scenario and Trends

This map shows % change from 2011

Contribution of FDI towards development

How can governments ensure that FDI boosts development?

Corporate Social Responsibility and FDI

THE DEVELOPMENT DIMENSION OF FDI: POLICY AND RULE-MAKING

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