metadata: authors: 0: author: Brewer, Thomas L.
docna: 0: docna: Foreign direct investment in developing
            countries : patterns, policies, and prospects
docty: Policy Research Working Paper
subtopic: Construction Industry,Mining & Extractive Industry (Non-Energy),Common Carriers Industry,Food & Beverage Industry,General Manufacturing,Pulp & Paper Industry,Plastics & Rubber Industry,Inflation,Macroeconomic Management,Business Cycles and Stabilization Policies
teratopic: Poverty Reduction
abstracts: cdata!: This study provides a summary of
            patterns, policies, and prospects concerning the foreign
            direct investment (FDI) in developing countries.  The focus
            of the study is on host country policies, but the policies
            of home governments and international institutions are also
            analyzed.  The emphasis of the study is on the factors that
            affect the patterns and trends of FDI in developing
            countries.  Implicit to the study is the theme that FDI can
            make significant contributions to the long-term development
            process and that policy reforms that contribute to greater
            FDI are consequently desirable.  The analysis of FDI
            presented here is based in substantial part on the findings
            of 11 country studies.  The author found that the public
            policy environment for FDI has improved in recent years.
            There is more appreciation of FDI's contributions (such
            as transfer of technology and managerial skills, export
            market development, stimulation of local entrepreneurship,
            competition and innovation) and greater appreciation of the
            role of the private sector and private investment in
            development.  The study concludes with a projection of the
            prospects for FDI flows to developing countries.
repnme: repnme: Foreign direct investment in developing
            countries : patterns, policies, and prospects
display_title: Foreign direct investment in
            developing countries : patterns, policies, and prospects
listing_relative_url: /research/1991/06/699941/foreign-direct-investment-developing-countries-patterns-policies-prospects
topicv3: Education, Skills Development and Labor
            Market m1326135 1484,Mining Services m1326410 1701,Manufacturing Sectors m1326521 1281,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Balance of Payments m1326965 441
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Poverty Reduction
origu: Policy, Research & Ect Affairs
no_of_pages: 66
author_keys: 0: author_key: 321144
model_extractions: **Plc,Research, and External Affairs**

<!-- Start of picture text --> XDebt and International Finance X<br>WPS 712<br><!-- End of picture text --> This paper-- a product of the Debt and International Finance Division Division, Internationial Economics Departmcnt--- is part of a largereffort in PRE to assess the potential for increasing foreign direct investment in support of economic development. Copies are available free from the World Bank, 1818 H Street NW, Washinigton DC 20433. Pleasc contact Sheilah King-Watson, room S8-045, extension 31047 (58 pages).

Drawing on the findings in 11 country studies, Brewer conk .jdes that the public policy environment for foreign direct investment (FDI) has improved in recent years. There is more appreciation of FDI's contributions (such as the transfer of technology and managerial skills, the development of export markets, and the stimulation of local entrcpreneurship, competition, and innovation) and greater appreciation of the role of the private sector and private investment in development.

But to improve the flow of FDI into develop- ment, more is needed especially changes in policies toward FDI and changes in macroeconomic policies and conditions.

Positive policy shifts have improvcd the climate for FDJ in Korea, Mexico, and Nigeria. Continuing restrictions limit FDI flows to India, Brazil, and some of the largest developing countries. Macroeconomric conditions and policies will continue to affect FDI flows and to dominate investors' decisions, as recent experiences in Mexico and Brazil indicate.

Policy reform designed to attract investors will be only marginally effective unless accompanied by appropriatc macroeconomic policies. Marginal, isolated policy changes are not enough. Investors risk estimates are highly sensitive to perceptions of change and unccrtainty.

Developed countries' guarantee programs to protect their own investors against noncommercial risks associated with FDI projects in devel- oping countries together with other developed - country promotional activities are an important part of the policy framework that affects FDI in developing countries.

Total FDI flows to developing countries are unlikely to rise significantly in the next few years. Average flows of about SDR 15 billion a year (or 1 percent of developing countries' GDP) are likely for the next threc years.

Absolute flows of FDI might increase significantly in some countries but the developing countries' share of total world FDI flows will probably remain relatively low (about 15 percent) largely because FDI in the United States will continue at high levels.

This paper was completed under the supervision of Kwang W. Jun. The background paper for this report is available on request. The background volume reviewed FDI experiences of 11 developing countries in three regions: Argentina, Bra/il, Colombia, and Mexico in Latin America; India, Indonesia, Malaysia, Korea, and Thailand in Asia; and Kenya and Nigeria in Africa. The main author of the background paper was Gyorgy Becsky. Other contributors were Young-Hoi Lee and Aloysius Ordu.

The PRE Working lpaper Series disseminates the findings of work under way in the Bank's Policy, Research, and Extemal AffairsComplex. An objectiveoftheseries is togettthesefindingsoutquickly, even if presentations are less than fully ;xlished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.

Produced by the PRE Dissemination Center
i

# CONTENTS

|Chapter 1. Introduction<br>....................................<br>1|
|---|
|Purpose and Scope of the Study ........................... 1|
|Data Issues<br>.............................<br>2|
|Chapter 2. Overall Patterns and Trends .....<br>................<br>4|
|Host countries and Regions<br>..<br>7|
|Source Countries<br>.............................<br>8|
|Sectoral Shares<br>..........................................<br>11|
|Chapter 3. Patterns and Trends in Eleven Host Countries<br>..... 14|
|Individual Country Trends ............... .................<br>15|
|Sectoral Concentration .......<br>............................<br>19|
|Source Country Concentration ..........**.**.<br>................<br>21|
|Chapter 4. Host Country Economic and Political<br>Environment ...................................<br>22|
|Size of Economy<br>..............................<br>22|
|Economic Policies ...............<br>...............<br>24|
|Political Stability ...............................<br>26|
|Chapter 5. Host Country FDI Restrictions and Incentives<br>..... 29|
|Summaries of Policies ................. ...................<br>30|
|Illustrative Recent Policy Charges ..........<br>.............<br>37|
|Debt-Equity Swaps<br>...................<br>.....................<br>40|
|Chapter 6. Policies of Home Governments and International<br>Institutions ..................................<br>41|
|Guarantees<br>...............................................<br>41|
|Other Issues<br>.....................<br>........................<br>43|
|Chapter 7. Outlook for the Future .......................... 45|
|Global Changes<br>..................................<br>45|
|Conclusions<br>.................<br>.................<br>47|
|Appendix<br>................<br>......... 48|
|Notes .........<br>52|
|References .........<br>55|
ii

# List of Tables

|Table 2-1|Absolute Magnitudes of FDI Flows to All<br>Developing Countries, 1975-88 ....<br>........|.....<br>4|
|---|---|---|
|Table 2-2|Relative Magnitudes of FDI Flows to All<br>Developing Countries, 1975-88 ....<br>........|....<br>5|
|Table 2-3|Components of FDI Flows to Developing Countries,<br>1975-88 ....................................|... 6|
|Table 2-4|FDI Stocks by Region of Host Developing<br>Country, Selected Years ......................|. 7|
|Table 2-5|FDI Flows by Region of Host Developing<br>Country, 1981-87 ............................|.. 8|
|Table 2-6|Home Country Shares of FDI Flows to Developing<br>Countries, 1975-87 ..........................|.. 9|
|Table 2-7|FDI Flows from Developing Countries, 1975-88....|10|
|Table 2-8|Sectoral Shares of FDI Stock in All Developing<br>Countries, Selected Years ....................|. 11|
|Table 2-9|Increases in Outward FDI Stock from the United<br>States and Japan by Sector and Region, 1977-85.|13|
|Table 3-1|Eleven Host Countries' Shares of Total FDI Flows<br>to All Developing Countries, 1975-88 .... ....|.. 14|
|Table 3-2|Time-series Regressions of FDI Flows for Eleven<br>Host Countries, 1968-87 ......................|. 19|
|Table 3-3|Sectoral Distribution of FDI Stocks in Eleven<br>Host Countries ..............................|.. 20|
|Table 3-4|Source Country FDI Stock Concentration Ratios in<br>Eleven Host Countries ........................|. 21|
|Table 4-1|GDP and FDI for Eleven Host Countries, 1978-87<br>...|<br>23|
|Table 4-2|Ratio of FDI Flows to GDP for Eleven Host<br>Countries, 1968-87 ..........................|.. 24|
# iiL

|Table 5-1.<br>Table 5-2|Trends in the Incidence of Expropriation, 1960-85<br> <br>FDI Policy Incentives and Disincentives .... ....|30<br>. 31|
|---|---|---|
|Table 5-3<br>Table 7-1|Major Dimensions of Host Courtry FDI Policies...<br> <br>Correlations among Data Series for FDI Flows .....|37<br>49|
|Table 7-2|Alternative Data Sources for FDI Flows Nigeria,<br>1979-81 .....................................|..<br>50|
iv

# List of Charts

|Chart 3-1<br>FDI Flows|in Four Latin|American Countries ......|<br>16|
|---|---|---|---|
|Chart 3-2<br>FDI Flows|in Five Asian|Countries ....<br>.......|....<br>17|
|Chart 3-3<br>FDI Flows|in Two Africa|n Countries ....<br>.......|...<br>18|

(The paper was completed, under the direction of Kwang W. Jun, in April 1991)
# Chapter **1**

# Introduction

The low level of foreign direct investment (FDI) in developing countries during portions of the 1980s, in combination with the increased burden of servicing their external debt, has prompted renewed interest in ways to facilitate FDI. This renewed interest has been reflected in more favorable policies toward FDI in the host countries and in the initiatives of international institutions. This increased activity has created a need for readily available information concerning patterns in FDI in developing countries, host country policies, and other conditions that affect investment.

# Purpose and ScoRe of the Study

This study provides a summary of patterns, policies, and prospects concerning FDI in developing countries. The focus oi the study is on host country policies, but the policies of home governments and international institutions also are analyzed. The study concludes with a projection of the prospects for VI flows to developing countries. it provides a wide-ranging treatment that is intended to serve as a basis for discussions about a variety of issues related to FDI.1 The emphasis of the study is on the factors that affect the patterns and trends of FDI in developing countries. Implicit to the study is the theme that FDI can make significant contributions to the long-term development process and that policy reforms that cont:.ibute to greater FDI are consequently desirable. The roles of the private sector in the development process, and the contributions of private FDI in particular have long been debated. It is, nevertheless, useful to review briefly the case in favor of fostering an even greater role for F!I In the long-term development process because much recent discussion about FDI has been slanted toward relieving the external debt burder. of developing countries, especially in the short term. Relief, however, has its price in the higher yields on FDI compared with interest on loans (Caprio, Gelb, and Johnson 1989). The recipient countries also face the riXk that if the investors repatriate capital, funds will be lost when most needed; if the recipients prohibit repatriation, they will lose their creditability.

Whatever its contribution to short-term debt relief may be, FDI can be u!nderstood and appreciated as a package of resources that complements other financial flows to developing countries and makes a distinctive contribution in the development process. Indeed, it is precisely the nonfinancial components of the direct investment package and their long-term effects that are often the most important in the development process. FDI projects typically involve a transfer of technology and managerial skills from the source country to the recipient country. Although the extent, form, and appropriateness of the technology are often at issue in individual projects, there is no doubt that in the aggregate FDI is an important channel for transferr'.ng technology and managerial skills to developing countries.
2 FDI projects also can provide greater access to world markets for hostcountry exports. Because of their ties to parent corporations in the home country and other affiliated corporations in third-country markets, FDI projects in developing countrios facilitate market penetration and market expansion in countries where they have corporate connections. Further benefits in the economy of the host country ran occur as the -sult of the stimulus FDI often gives to local entrepreneurs, competitors, and nnovators. The entry of a foreign firm using different components or assembl) techniques, for example, can have such effects.

In addition to these benefits of FDI are the usual employment and incomegenerating effects of an investment--whether undertaken by a domestic or foreign firm--and the immediate or long-term balance of payments effects of the associated international financial flows. There are, of course, social costs as well as benefits associated wich FDI projects. For instance, FDI can have adverse effects in a highly protected environment, by leading to high cost production. There are, moreover, important issues about the distribution of the costs and benefits within and between the host and home countries. Although these additional considerations can mitigate ard complicate the net beneficial effects of FDI in the host country, they do not alter the contribution that FDI can make in the long-term development process. There is therefore a need for countries to adopt policies that are more conducive to FDI so that its role in the development process can be expanded.

The analysis of FDI presented here is based in substantial part on the country studies that appear in Foreign Direct Investment in Selected De loping Countries in the Last Two Decades by Gyorgy Becsky, Young-Hoi Lee, and Aloysius Ordu. Those recently completed jtudies concern FDI in eleven countries: Argentina, Btazil, Colombia, and Mexico in Latin America; India, Indonesia, Malaysia, Republic of Korea, and Thailand in Asia; and Nigeria and Kenya in Africa. Those countries were selected for their geographic, economic, and policy diversity; they include both oil exporters and oil importers. Some of the countries have adopt-d relatively restrictive policies toward FDI, while others have been more open, especially in recent vears. Mosz of them are major FDI recipients, and many are newly industrialized co'-ntries with substantial exports of manufactured goods. They have collectively been the recipients of approximately half of the FDI flows to all de -eloping countries during the past decade. In total, these eleven countries provid , useful sample for the study of FCI.

# Data Issues

Foreign direct investment is a long-term investment that can include new equity investments, reinvested earnings, and related lending. Any given investment can involve establishing, acquiring, or expanding an affiliated subsidiary corporation or branch. An essential element of a direct investment (contrasted with a portfolio investment) is a continuing substantial interest ir., and an effective voice in, managing the real assets of a foreign affiliated entity. An ownership share of at least 10 to 25 percent is commonly considered the minimum threshold for an investment to be considered a direct investment, but the essential ingredient is control over asbets. Where there is no eubstantial influence in the management of the foreign enterprise, the investment is
3

# considered a portfolio equity investment.2

There are numerous sources of data on PDI, and no single source is by itself necessarily adequate for a given purpo.e. For the most part, this study uses data on FDI flows reported by the International Monetary Fund's (IMF) Balance of Payments Statistics Yearbook and International Financial Statisiics. The IMF's data on FDI have several virtues: they provide relatively comprehensive country coverege, extend over many years, are based on a broad notion of FDI, and facilitate cross-national comparisons. In preparinlg these two volumes, IMF data have been supplemented by data froin she Organization for Economic Co-operation and Development (OECD), t-he Unitad Nations Centre on Transnational Corp rations (UNCTC), national governments, and other organizations and individuals.

One important difference between this paper and earlier World Bank Staff Working Papers on FDI is the principal source of FDI data that has been used.<sup>3</sup> Whejreas the present paper relies primarily on IMF data, the previous papers relied extensively on OECD data. Thus, any comparisons between data in those papers and the present volume should be made with considerable caution; this is particularly true with regard to time series analyses that extend back in ti-" prior to 1975.4 Appendix 1 of this report provides an in-dcpth oomparison between alternative sources of FDI data.

Despite these data issues, basic patterns and trends can be discerned for the developing countries as a whole (see chapter 2) and for the eleven selectee countries (see chapter 3). Following these descriptions of the centra' tendencies and variations in the basic data, subsequent chapters consider the variables that influence these patterns and trends. Chapter 4 considers the host country economic and political environment, chapter 5 considers host country FDI policies, and chapter 6 considers the policies of home governments and international institutions. Chapter 7 concludes the study with an analysis of the prospects for the future of FDI in each of the eleven selected countries, as well as for all developing countvies collectively.
4 Chapl'er 2

# Overall Patterns and Trends

Frcm the 1950s until the mid-1960s, net FDI flows to devLloping _countries_ remained at relatively low leveis of $2 billion dollars or .ess a year. During this period there was substantial disinvestment--some voluntary, some forced--ir petroleum, mining, agriculture, and manufacturing. Beginning in the late 1960s annual net flows increased until they reached a peak in 1981 of $'5.3 billion, or about one-half percent of th-. developing countries' GDP. These increased flows of FDI were responses to the combination of ec nomic growth and industrialization in several large developing countries, more hospitable policies in some of the host countries, and more flexible policies on the part of investors.

The four-year period from 1983 through 1986 was marked by lower levels of annual flows of $10.2 billion to $11.2 billion (SDR9.7 billion to SDR9.2 billion). In the latter part of the decade, however, there was a modest reversal, with annual flows exceeding $15 billion (see table 2-1 for additional details on the absolute magnitudes of the flows).

Table 2-1: Absolute Magnitudes of FDI Flows to All Developing Countries, 1975-88

|Year|SDRs|Current U.S.<br>dollars|Constant U.S.<br>dollrars|
|---|---|---|---|
|1975|5.4|6.3|10.0|
|1976|4.1|4.8|7.6|
|1977|5.5|6.7|7.4|
|1978|6.1|8.0|9.9|
|1979|7.9|10.3|11.3|
|1980|8.6|10.9|10.9|
|1981|13.1|15.3|15.2|
|1982|12.3|13.6|13.8|
|1983|9.7|10.2|10.5|
|1984|10.3|10.1|10.7|
|1985|11.6|12.7|13.4|
|1986|9.2|11.2|10.0|
|1987|11.d|16.7|13.6|
|19888|1?.7|18.5|13.9|

a. Preliminary figures.

Source: IMF
5 Shifts in t-he relative importance of FDI in the total flow of financial resources to the developing countries are appa'rent in table 2-2. Although FDI flows were only 12.8 percent of the total net flow of financial resources in 1980, they had increased to 20.9 percent in 1986, and according to preliminary figures, to 33.4 percent in 1987. This reflects the slowdo~'n in bank lending co developing countries. In table 2-2 it is also apparent that FDI flows<sup>to</sup> developing countries have declined considerably as a percentage of total world FDI --from 29.5 percen±t in 1975, to 23.8 percent in 1980 and to 13.7 peicent in 1988. The counterpart to this decline was a large increase in FLI in the industrial countries, especially the United States. The amoun; of FDI in relation to the recipient developing countries' economies declineJ uncil 1986 after peaking in 1981-82.

Table 2-2. Relative Magnitudes of -D; Flows to All Developing Countries, 1975-1988 (percentage)

|Year|Total World<br>FDI flows|<br>Net_f.ow_of<br>Finan-ial<br>resources<br>to developing<br>countries|GDP of<br>developing<br>countries<br>|Gross domestic<br>investment in<br>developiong<br>countrles|
|---|---|---|---|---|
|1975|29.5|15.0|0.8|3.0|
|1976|27.3|10.8|0.5|2.1|
|1977|25.7|12.2|0.5|1.8|
|1978|24.0|12.2|0.5|1.8|
|1979|24.8|13.6|0.5|2.0|
|1980|23.8|12.8|0.5|1.8|
|1981|24.6|14.6|0.6|2.3|
|1982|25.5|14.7|0.6|2.2|
|1983|21.7|13.7|0.4|1.8|
|1984|20.0|15.3|0.5|1.8|
|1985|24.9|20.2|0.5|2.2|
|1986|14.6|20.9|0.5|2.1|
|1987|14.3|33.4|0.7|2.9|
|19888|13.7|--|0.7|2.7|

-- Not available

a. Estimated figures.

Source: IMF
6 In table 2-3 it is evident that the proportions of the principal components of FDI--new equity, reinvested earnings, and FDI-related borrowing--have also shifted over time. The new equity component had thus increased to over 65 percent of total FDI flovs to developing countries by 1988 -up from 23 percent in 1977 and 46 percent in 1982.9 Meanwhile, the proportions for both reinvested earnings and FDI-related borrowing had decreased. In 1988 rsinvested earnings were S percent and borrowing 25 percent of the total flows. There were important individual country exceptions to these trends, however. For instance, although the relative importance cf reinvested earnings in Brazil exhibits substantial year-to-year fluctuations, there has not been the same downward trend over the past decade that the worldwide data reveal.

Table 2-3: Components of FDI Flows to Developing Countries, 1975-88 (percent)

|Year|Equity|Reinvested<br>earnings|Long-term<br>borrowing|Short-term<br>borrowing|
|---|---|---|---|---|
|1975|27.1|18.3|54.4|0.2|
|1976|12.9|30.4|59.3|-2.6|
|1977|23.4|28.1|50.2|-1.6|
|1918|36.9|29.5|34.5|-0.9|
|1979|42.0|23.1|39.0|-4.2|
|1980|52.5|24.7|23.6|-0.8|
|1981|46.3|19.7|34.6|-0.6|
|1982|45.5|22.6|30.7|1.2|
|1963|44.0|15.8|40.9|-0.7|
|1984|57.5|14.2|26.0|2.3|
|1985|53.6|17.4|33.3|-4.3|
|1986|54.3|20.0|26.0|-0.6|
|1987|62.0|14.5|23.1|0.4|
|1988|66.7|9.1|24.2|0.4|

Nute: These are -:et figures, for example, new equity less divestment. See IMF (1977), p.140, para. 419-20.

Source: IMF.
7

# Host Countries and Regions

FDI in the developing world has consistently been concentrated in a small number of individual countries. This was true in an earlier era, when investmentd in the primary sector predominated, and it has also been true in recent years, when manufacturing investments have been more common. Thus, a few economically large or upper-middle-income countries in Latin America and Asia have been the principal recipients, and the regional distributions generally reflect these country concentration patterns.

Table 2-4 lists the escimated regional distributions of FDI stocks. In 1960 orn-half of the FDI stock in developing countries was in Latin America, with slightly less than one-fourth in Asia. During the 1960s the share in Latin America irncreased and the share in Asia decreased, while other regions' shares did not change significantly. Then, during the 1970s, the Asian share increased, while the Latin American and Africarn shares decreased--trends that continued in the _1sOs._ Table 2-4. FDI Stocks by Region of Host DevelopLng Countries, Selected Years (percent of all developing countries)

|Rep-ion|1960|1971|1980|
|---|---|---|---|
|Latin America|48.3|57.6|53.1|
|Africa|17.0|17.1|10.6|
|Asia|23.3|15.2|25.8|
|Middle East|8.5|6.8|3.5|
|Europe|2.8|3.3|7.1|

Source: Stopford and Dunning (1983), as reported in OECD (1987), table 3-2, p.<sup>187</sup> .
8 In table 2-5, where yearly flows are given, the increased share going to Asian countries is apparent. By 1985-86 one-third of all FDI flows to developing countries was going to Asian countries. Among Latin American countries, Colombia has been an exception to the general decline in FDI during the 1980s. After several years of declining investor interest in the early 1980s, FDI in Mexico increased substantially in the late 1980s. Overall, however, by 1986 the Latin American countries' share of FDI flows had declined to 24.6 percent.

Table 2-5. Foreign Direct Investment Flows Region of Host Developing Countries, 1981-87 (percent of all developing countries)

|Region|1981|1982|1983|1984|1985|1986|<br>1987|
|---|---|---|---|---|---|---|---|
|Latin America|35.5|24.5|21.2|20.4|31.6|24.6|<br>46.4|
|Africa|7.0|6.9|7.2|6.7|6.4|5.6|5.6|
|Asia|22.1|17.6|31.0|28.8|37.6|32.8|<br>51.6|
|Middle East|31.3|48.1|35.8|38.5|17.3|30.8|<br>-13.8|
|Europe|4.4|3.0|5.5|5.7|6.8|6.2|<br>10.3|

Source: IMF.

Uritil 1989, FDI in China had been increasing substantially--from SDR389 million in 1982 to SDR1,598 million in 1986 (Pfeffermann 1988). Elsewhere in Asi4, FDI flows have also increased--in recent years the Republic of Korea, and in earlier years to Malaysia, Singapore, and Indonesia have received increased shares. As noted in the section entitled "Sectoral Shares," the geographic distribution trends for FDI are affected by the large amounts of FDI in off-shore banking centers and in flags-of-convenience shipping.

# Source Countries

There has been a high degree of concentration in FDI flows by source country (table 2-6). Five countries--the United States, United Kingdom, Federal Republic of Germany, France, and Japan--have accounted for 80 percent or more of the total FDI flows to developing countries. The U.S. share had been around 4060 percent in the late 1970s, but declined in the 1980s. In contrast, Japan's share rose from 10.9 percent in 1975 to 37.2 percent in 1987. The three European countries' individual and collective shares have fluctuated from year to year, but exhibited no strong trends over the 1975-87 period.
9 Table 2-6. Home Country Shares of FDI Flows to Developing Countries, 1975-87 (percent)

|Year|United<br>States|United<br>Kingdom|Fed. Rep.<br>of Germany|France|Japan|Total|
|---|---|---|---|---|---|---|
|1975|63.8|5.8|7.2|2.4|10.9|90.0|
|1976|37.4|10.0|9.2|2.9|22.3|81.9|
|1977|49.4|12.0|8.6|2.7|11.6|84.3|
|1978|48.0|7.0|8.8|3.5|17.3|84.7|
|1979|60.5|5.2|6.2|5.1|10.4|87.3|
|1980|30.9|17.6|14.5|8.3|15.4|86.6|
|1981|38.4|13.8|8.0|6.7|23.3|90.3|
|1982|44.1|10.5|8.0|7.6|18.9|89.1|
|1983|25.6|16.2|9.2|4.4|19.4|74.8|
|1984|39.7|18.9|6.3|2.4|15.6|82.9|
|1985|14.4|32.6|-2.2|9.0|15.5|69.2|
|1986|27.9|17.1|3.7|5.5|27.8|82.0|
|1987|40.3|9.5|3.4|3.5|37.2|93.8|

Note: All percentages are of outflows from OECD countries only, not world totals.

Source: OECD.
10 Another development in the past decade has been an increase in FDI flows from developing countries. Multinational firms from Brazil, for instance, have undertaken investments in the countries of West Africa and in other developing areas. Meanwhile, Brazil has received investments by 1985 from such developing economies as Kuwait, Saudi Arabia, South Africa, Iran, Portugal, and Hong Kong--although they totalled less chan 2 percent of Brazil's the FDI stock.

Malaysia, Singapore, and Hong Kong are unusual among developing economies in the extent to which they are both recipients of and sources of FDI, which reflects the intense activity in intraregional FDI in Southeast Asia.<sup>10</sup> Malaysia is especially prominent for the high proportion of FDI that has come from other developing countries as of 1983, 44 percent of its FDI stock in "pioneer industries" was from non-OECD countries, inctluding 33 percent from Singapore. Five Asian developing countries exhibit relatively high proportions of FDI stocks from other developing countries: Thailand, 17.6 percent in 1984; India, 13.2 percent in 1974; Indonesia, at least 9.6 percent in 1983; and the Republic of Korea, close to 9 percent in 1986. In three of the Latin American countries, the comparable figures were generally less than 5 percent. (There are no directly comparable data for Argentina, Nigeria, or Kenya.) Table 2-7 lists additional data on FDI; those data indicate FDI flows from developing countries were usually about I.D percent of world totals. Three-fourths of the outflows were from Latin American countries.11 Table 2-7. FDI Flows from Developing Countries, 1975-87

|Year|SDRs (millions)|Percent of total<br>world FDI|
|---|---|---|
|1975|181|1.0|
|1976|313|2.1|
|1977|310|1.4|
|1978<br>|299|1.2|
|1979|332|1.0|
|1980|485|1.3|
|1981|325|0.6|
|1982|1,057|2.2|
|1983|721|1.6|
|1984|448|0.9|
|1985|1,101|2.4|
|1986|938|1.5|
|1987|1,223|1.5|
|1988|1,159|1.2|

Source: IMF.
11 It should also be noted that the centrally planned economy and Council for Mutual Economic Assistance (CPE-COMECON) countries of Eastern Europe are source countries of FDI in developing countries--although at relatively modest levels (McMillan 1987, pp.33-46). In 1983 there were at least 213 COMECON FDI projects in 75 developing countries, including Mexico, India, and Nigeria, with a disproportionate number in Africa. The total stock of these investments, however, has been estimated at only $1 billion to $2 billion (out of a worldwide total COMECON FDI stock of approximately $4 billion to $6 billion in 1983) (McMillan 1987, p.40). This compares with a total FDI stock in all developing countries from all sources of approximately $200 billion.11 In addition to the FDI from the state enterprises of the COMECON countries, there is also outward FDI by the state economic enterprises (SEEs) of developed and developina countries. Unfortunately, the readily available data on FDI flows and stocks do not separate the portion of FDI from SEEs in the developed or developing countries, but the share of FDI in developing countries controlled by home country SEEs is low.

# Sectoral Shares

A sectoral analysis of the shares of FDI must be qualified by the data's limitations. Nevertheless, some patterns and trends can be observed in the data presented in tables 2-7 and 2-8. Although these data do not extend back far into the past, it is well known that FDI in manufacturing began to increase in importance compared with the earlier emphasis on FDI in the primary sector before the 1970s (table 2-8)." Table 2-8. Sectoral Shares of FDI Stock in All Developing Countries, Selected Years (percent)

|Sector|1971|1975|1978|1982|
|---|---|---|---|---|
|Extractive|22.9|26.7|12.8|22.6|
|Manufacturing|59.0|53.2|64.5|54.1|
|Services|18.1|20.1|22.7|23.3|

Source: Dunning and Cantwell, (1987), table B2, p. 793, and table B3, p.795 for 1975 and 1982 respectively; Stopford and Dunning (1983), as reported in OECD, International Investment and Multinational EnterRrises (1987) table 3-12 on p. 197, for 1971 and 1978.
12 Within the manufacturing sector there was an important shift that is not revealed by the data in those tables but that has been frequently noted (see, for example, OECD 1987, pp. 38-40). Manufacturing FDI was strongly oriented toward import substitution projects for rapidly growing markets, especially in Latin America, until the 1970s. Starting in the 1970s and continuing into the 1980s, however, the emphasis in manufacturing FDI shifted to low production cost, export-oriented projects. This shift in corporations' strategic emphasis within manufacturing goes hand-in-hand with the regional shift noted above--the decreasing proportions of FDI in Latin America and the increasing amount in Asia.

At the same time, the share of FDI in services increased from 20.1 percent in 1975 to 23.3 percent in 1982. This increase in the share of FDI in services, is highly concentrated in the financial services industry, especially in offshore centers.

Several of these patterns and trends are evident in some detail **iti** table 2-9, where increases in U.S. and Japanese direct investments are broken down by sector and by region. The large increases in FDI in services by both the United States and Japan, for instance, can be noted- -as can the large amounts of U.S. investment in offshore financial centers.
13 Table 2-9. Increases in outward YDI Stock fro the Ubited Statea and Japan by Sector sad Raglen, 1977-85 (U$8 billions, increase from 1977 to 1985)

||Latin<br>Amorica|Offshore<br>Centers'|Asia|Africa|Middle<br>East|All<br>developing<br>countries|
|---|---|---|---|---|---|---|
|UNITED S_iATES|||||||
|Primary'|2.3|0.6|4.3|2.7|7.1|17.1|
|Manufacturing|5.3|0.4|2.0|0.1|0.3|8.2|
|Servicesa|1.7|12.7|3.1|0.1|1.0|17.8|
|Banking|0.4|3.8|0.9|0.2|0.2|5.4|
|Financial insurance|||||||
|real estate|0.8|8.5|0.6|-0.1|-0.1|9.8|
|Whole&ale trading|0.3|0.5|1.3|0.0|0.5|2.6|
|All industries|9.3|13.7|9.4|2.9|8.4|43.1|
|JAPAN|||||||
|Primary'|1.0|n.a.|4.8|0.2|0.2|5.2|
|Manufacturing|2.5|n.a.|5.5|0.1|0.8|8.5|
|<br>Servicesd|8.3|n.a.|5.5|2.1|-0.2|14.3|
|Financial and|||||||
|insurance|1.5|n.a.|0.9|0.0|0.1|2.1|
|Real estate|0.0|n.a.|0.4|0.0|-0.4|-0.1|
|Trading|0.8|n.a.|1.4|0.0|0.0|1.7|
|All industries|11.9|n.a.|16.0|2.5|1.5|28.9|

n.a. Not available.

a. Bahamas, Bermuda, Panama, Trinidad and Tobago, and other Caribbean islands. b. Asia and Pacific for United States, Asia plus Oceans for Japan.

c. Includes petroleum, mining, forestry, agriculture and fishing. For U.S. figures for Latin America and offshore centers, one-half of the "other industries" plus "other services" sum has been allocated to the primary sector.

d. Services totals do not equal sums of the subtotals for the more refined industry grouping because some subtotals have been omitted. The services totals were computed by subtracting the primary and manufactuing sectors from the overall totals for the United States in order to correct for its contamination by some primary-sector projects in the source tables. Source: United Nations Centre on Transnational Corporations (1988), annex tables C-1 and C-2, p. 589. Some lines in the source tables have been aggregated and others deleted to simplify the present presentation.
14

# Chapter 3

# Patterns and Trends in Eleven Host Countries

The eleven countries selected for the studies in<sup>Becsky, Lee, and Ordu</sup> (1990) include many of the principal FDI host<sup>countries, including Brazil,</sup> Malaysia, and Mexico. Collectively, these eleven countries<sup>accounted for more</sup> thar. half of the FDI inflows into all developing countries<sup>in each of the years</sup> from 1975 through 1983; from 1984 through 1988 they<sup>accounted for nearly</sup> one-half, as indicated in table 3-1.

Table 3-1. Eleven Host Coumtries' Share of FDI FlOws to A11 DeveOLping **Csmntries.** 1975-88 (percent)

|Country|1975|1976|1977|1978|1979|1980|1981|1982|1983|1984|1985|1986|<sup>1987</sup>|<sup>1988</sup>|
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
|Argentina|n.a.|n.a.|2.2|3.2<br>|1.9<br>|6.1<br>|5.4<br>|1.7<br>|1.8<br>|2.6<br>|7.5<br>|5.3<br>|-0.1<br>|6.2<br>|
|Brazil|21.0|32.6|28.1|25.7|22.7|17.1|16.5<br>|22.1<br>|15.2<br>|15.8<br>|11.2<br>|3.0<br>|8.0<br>|0.0<br>|
|Colombia|0.6|<br>0.5|<br>1.0<br>|<br>1.4|<br>1.2<br>|<br>1.4<br>|<br>1.7<br>|2.8<br>|6.0<br>|5.8<br>|8.4<br> <br>|6.2<br>|2.1<br>|1.2<br>|
|Mexico|9.8|13.2|8.5|10.7|12.5|19.2|18.6|12.4|4.4|3.9|<br>4.1|14.0|21.1|14.0|
|India|1.6|<br>1.2|-0.7|<br>0.3|<br>0.6|0.9|<br>0.7|0.6<br>|0.1<br>|0.2<br>|<br>0.9<br> <br>|<br>1.3<br> <br>|1.3<br>|1.3<br>|
|Indonesia|7.7|<br>7.2|<br>3.7|<br>3.6|<br>2.1|<br>1.6|<br>0.9|<br>1.7|2.8|2.2|<br>2.5|<br>2.4|2.9|2.9|
|Korea.|||||||||||||||
|Rep. of|0.9|<br>1.7|<br>1.4|<br>1.2|<br>0.3|0.1|<br>0.7<br>|<br>0.5<br>|<br>0.7<br>|1.1<br>|<br>2.0<br> <br>|<br>3.9<br> <br>|3.9<br>|4.7<br>|
|4Malaysi|a 5.7|<br>8.0|<br>6.2|<br>6.4|<br>5.4|<br>8.3|<br>8.3|10.6|12.3|7.9<br>|<br>5.7<br> <br>|<br>4.5<br>|2.8<br>|3.5<br>|
|Thailand|0.4|<br>1.7|<br>1.6|<br>0.7|<br>0.5|<br>1.7|<br>1.9|<br>1.5|<br>3.4|<br>4.0|<br>1.3|2.4|2.3|6.0|
|Kenya|0.3|<br>1.0|0.9|<br>0.4|<br>0.8|0.7|<br>0.1|<br>0.1|<br>0.2|<br>0.1|<br>0.1|<br>0.3|0.4|0.1|
|Nigeria|6.7|<br>7.1|<br>6.8|<br>2.7|2.9|-6.6|3.6|<br>3.2|<br>3.4|<br>1.9|<br>3.9|<br>1.8|3.9|4.5|
|TC'AI.|52.9|72.9|60.3|56.1|50.4|49.5|57.7|56.6|<sup>50.3</sup>|<sup>45.2</sup>|<sup>46.6</sup>|<sup>44.0</sup>|<sup>47.3</sup>|<sup>43.2</sup>|

n.a. not avaiLable Source: IMP.
15 The patterns and trends in FDI in these eleven countries inevitably reflect the same dynamics at the global and regional levels, but the differences in the patterns and trends in FDI among the countries are at least as striking as the similarities. Indeed, the relative ltt', pendence of FDI flows among these eleven countries is apparent in weak correlations in FDI flows for each pair of countries; even the intra-regional country-pair correlations are generally weak. Neither at the global level nor within regions do FDI flows to developing countries fluctuate in synchrony; rather, each host country's experience is relatively autonomous.

# Individual Country Trends

Time series data in constant U.S. dollars for FDI flows to the eleven countries are displayed in charts 3-1 to 3_3.14 Among the eleven countries, Brazil is unique in the pattern of substantial increases into the early 1970s, relatively high levels into the early-1980s, and precipitous decreases since the early 1980s. In the other Latin American countries the large fluctuations in the early and mid-1980s are the most obvious similarity across the selected countries. In Colombia the surge of FDI in the early to mid-1980s is conspicuous among the eleven countries in the -agree of its deviation from an otherwise stable and relatively low-level pattern over the two decades from the late 1960s to the late 1980s. Average annual flows were greater at the end of the period than at the beginning for Argentina, Colombia, and Mexico; nevertheless, the year-to-year fluctuations around the relatively high levels in the 1980s were so great compared with the earlier years that one cannot be confident about any generalized description of a long-term trend.
16

# Chart 3-1. ID! Flown in Four Latin American Countries (in US$ billions)

<!-- Start of picture text --> I~~~~~~~~~~~~~~~~~~~<br>* / ~~~~Mexko ##C -<br>0~~~~~~~<br>i 1970 IS7S 1974 t93 I978 11 I s192t Is" 19B<br><!-- End of picture text --> Among the five Asian countries over the twenty-year period, there was a general trend of increasing flows, but there were significant positive and negative deviations from this basic trend in each country. Furthermore, each country graph reveals a distinctive profile over time. Except for a large dip in 1973-74, Indonesia experietLced increasing flows from the late 1960s to the mid1970s, and relative stability since. India experienced overall low levels throughout the period. FDI flows into Korea were relatively stable at low levels but then increased over the 1984-87 period. Malaysia and Thailand both experienced relatively large magnitudes of inflows in 1974 and again in the early 1980s (1982 was a peak year for Malaysia and 1984 for Thailand).
17

# Chart 3-2- FDI Flows in FLvy Asian Countries (in US$ billions)

<!-- Start of picture text --> Ij Nore ,<br>UN MD an. nN a<br>1"86 90 1 lmd 1978 3M18 78 17<br><!-- End of picture text --> Reflecting the record of other African countries, Kenya and Nigeria were experiencing lower levels of FDI inflows (in constant dollars) at the end of the 1980s than at the beginning; the basic trend for Nigeria has been one of decline for the two-decade perlod, while Kenya experienced a :'ositive though moderate inflow throughout the perlod. Whereas Kenya's inflows reveal no volatility, Nigeria experienced a large but brief negative deviation in 1980.15
18 Chart 3-3. FDI Flows in Two<sup>African Countries</sup> (in US$ millions) <!-- Start of picture text --> " ~~~~~~~~~~Nig /<br>40<br>419<br>n;o onV m i<br>181 191 192) 1875 1977 111X9 1921 IS ' 2892| 1927<br><!-- End of picture text -->

Summary data on the long-term trends and year-to-year fluctuations in those trends are presented in table 3-2, based on linear regressions for each of the eleven countrles. The differences across the countries in the<sup>long-term</sup> trends, as indicated by the<sup>slope coefficients,</sup> are apparent. Argentina, Colombia, and Malaysia experienced annual increases (indicated by the slope) exceeding 10 percent of their mean FDI flows<sup>for the period,</sup> but the comparable figures for the other countries were quite low. Even more pronounced, however, is the degree of departure from the trend of the annual<sup>flows to individual</sup> countries, as indicated by the (small) R-squares.
19 Table 3-2. Time-Series Regressions of FDI Flows for Eleven Host Countries, 1968-87

|Country|Slope<br>coefficient (b)e|Coefficient of<br>(R<sup>2</sup>)|Slope as percent<br> <br>average EDI__|
|---|---|---|---|
|Argentina<br>|+0.029<br>|.31<br>|11.6|
|Brazil<br>|+0.002<br>|.00<br>|0.1|
|Colombia<br>|+0.030<br>|.41<br>|12.5|
|Mexico|+0.044|.14|3.7|
|India<br>|+0.001<br>|.01<br>|1.0|
|Indonesia<br>|+0.003<br> <br>|.01<br>|1.2|
|Korea, Rep. of<br>|<br>+0.004<br>|.05<br>|3.6<br>|
|Malaysia<br>|+0.037<br>|.35<br>|17.3|
|Thailand|+0.006|.13|3.3|
|Kenya<br>|-0.001<br>|.04<br>|-3.3<br>|
|Nigeria|-0.029|.26|-6.9|

a. Billions of constant 1980 U.S. dollars a year.

# Sectoral Concentration

The eleven hbst countries also vary in the degree of concentration within sectors (table 3-4). Brazil and Mexico are notable for their high proportions (three-fourths) of FDI in the secondary sector, and Indonesla and Colombia are notable for having 60 percent or more of their FDI in the primary sector, mostly in oil and gas. Korea, Malaysia, and Nigeria stand out for their relatively large proportion of FDI in services. By 1986, 40.2 percent of Korea's FDI stock was in the tertiary sector--including 27.4 percent in hotels (in anticipation of the Olympic games in 1988i) and 7.1 percent in banking and finance (following liberalization of banking regulations); furthermore, FDI in insurance is expected to increase as a result of li6eralization of restrictions on FDI in that industry.

Malaysia and Nigeria, exhibit an unusual degree of diversification, with substantial proportions of their FDI stock in each of the sectors. Such a diversification of FDI across sectors is advantageous to a given host country because it mitigates cyclical fluctuations associated with individual sectors, especially the primary sector.
20

**table** 3-s. Becteral Distribution of FDI Stoeka in 8l1vme Host Countries (percent of total)

|Country|Primary|Secondary|TertiAryX|Yea|
|---|---|---|---|---|
|Argentina|27.4|48.3|23.3t|1976-83|
|Brazil|13.5|74.7|19.2|1985|
|Colombia|61.0f|29.0'|10.0'|1985|
|Mexicod|n.a.|76.0|n.a.|1984|
|India|15.8|55.2|29.0|1974|
|Indonesia|62.5|n.a.|n.a.|1983|
|Korea, Rep. of|0.7|59.2|40.2|1986|
|Malaysia|26.9|33.5|39.Ob|1972-81|
|Thailand'|n.a.|33.0'|n.a.|1984|
|Kenya|3.1|64.3|32 <sup>. </sup>6 <sup>b</sup>|1985|
|Nigeria|28.4|30.1|41.5b|1986|

# a.a. Not Available.

Note: Figures do not add to 100.0 for some countries because of unclassified projects, imprecise estimiates, or rounding.

a. Latest year available in Becsky, Lee, and Ordu (1990). Where multiple years are shown, the stocks are based on the cumulative flows for the indicated years only.

b. Estimates computed from figures for other sectors or computed from estimates in original source.

c. Rounded estimates in Becsky, Lee, and Ordu (1990).

d. The 76 percent figure for Mexico is based on the country study estimate. of 74-;_ percent depending on the year. The latest year for the sectoral distribution is 1984.

e. The Indonesia country study estimates "nearly 10 billion" in energy out of a total of "nearly 16 billion".

f. The Thailand country study estimates "one-third" in manufacturing.

Sgogre: Becsky, Lee, and Ordu (1990). tables 2-6, 3-5, 4-3, 5-22, 6-9, 7-4, and 7-7.
21

# Source Country Goncentration

Over time, as FDI accumulates, a single source country may come to dominate the stock of FDI in a given recipient country. A relatively high degree of source-country concentration can create greater nationalistic sensitivities about FDI and vulnerability to shifts in the FDI policies of the home governments and corporations. Among the eleven countries, there is considerable variance in the source-country concentration ratios presented in table 3-5. Four of the host countries exhibit ratios of 60 percent or more: Kenya, where the British colonial legacy is still apparent; Colombia and Mexico, where the proximity to the United States is a factor; and Indonesia, where proximity to Japan is significant. The concentration ratios exceed 50 percent for two other countries-Nigeria (United Kingdom, 54.5 percent) and Korea (Japan, 54.9 percent).

Table 3-4. Source Country FDI Stock Concentration Ratios in Eleven Host Countries

|Host<br>country|Perceng|Source<br>Country|Yeara|
|---|---|---|---|
|Argentina|39.7|U.S.|1976|
|Brazil|31.4|U.S.|1985|
|Colombia|67.0b|U.S.|1986|
|Mexico|66.0|U.S.|1984|
|Indonesiac|60.0|Japan|1983|
|Korea, Rep. of|54.9<br>|Japan|1986|
|Malaysia|n.a.<sup>0</sup>|Singapore|1987|
|Thailand|30.2|U.S.|1984|
|Kenya|67.0|U.K|1972|
|Nigeria|54.5|U.K.|1986|

# n.a. Not available

- a. Latest year available in Becsky, Lee, and Ordu (1990).

- b. Rounded to nearest percent in original source.

- c. Based on U.K. figure for 1987 (estimated) against total for 1984 in original table, Singapore's share would be greater than 18.5 percent.

- d. Estimates from the country study for total FDI. Smaller estimates of 42.1 percent and 48.2 percent in Table 5.5 are for BKPM jurisdiction FDI projects only. Using data in Table 5.3, the figure would be 54.3 percent.

- Source: Becsky, Lee, and Ordu (1990), tables 2-7, 3-6, 3-11, 3-15, 4-4, 5-7, 5-11, 6-4, 6-8, 7-5, and 7-11.
22

# Chapter 4

# Host Country Economic and Political Environment

Macroeconomic and political conditions<sup>are the most important host-country</sup> variables affecting investors' FDI<sup>0-cisions. Because host-country economic</sup> conditions affect FDI projects in<sup>the same way that they affect domestically</sup> owned projects, a broad range of host-country<sup>economic policies is pertinent to</sup> foreign direct investors' operations.<sup>Some policies, such as wage and price</sup> controls, have direct effects on FDI<sup>projects; other policies, such as monetary</sup> and fiscal policies, can have important<sup>indirect effects.</sup> The eleven selected host countries<sup>have varied substantially in their</sup> approach to such economic policies<sup>and in their responses to external and</sup> internal shocks. Whereas some countries<sup>have been inclined to alter government</sup> policies in response to changing<sup>circumstances and to allow market forces to</sup> operate in the balance of payments<sup>adjustment process, others have pursued</sup> government policies that constrain the<sup>adjustment process, at least in the short</sup> term. Yet, whatever the vicissitudes<sup>of macroeconomic conditions and policies,</sup> one ever-present key determinant<sup>of FDI is host-country economic size.</sup>

# Size of Economy

Numerous studies of FDI have found<sup>that aggregate national market size, as</sup> indicated by host country GNP or GDP,<sup>is related to variations across countries</sup> in the levels of FDI inflows<sup>(Scaperlanda and Hauer 1969; Kobrin 1976).</sup> Similarly, a pooled time-series, cross-sectional regression of FDI flows on GDP for the eleven selected countries<sup>over the 1968-87 period found them to be</sup> positively related (and statistically<sup>significant at the .001 level). The</sup> relationship of variations among<sup>countries in the level of FDI flows to host-</sup> country economic size is also demonstrated<sup>in table 4-1.</sup> Real growth rates in GDP have been<sup>found to be correlates of FDI flows by</sup> some studies (Root and Ahmed 1978),<sup>furthermore,</sup> economic stability, as measured by the inflation rate, can be an<sup>important variable in the host-country economic</sup> environment. A pooled time-series,<sup>cross-sectional</sup> multiple regression of FDI flows on GDP, growth rates, and<sup>inflation rates for these eleven countries during</sup> 1968-87 period was therefore undertaken;<sup>it reveals an R-square of only 0.11.</sup> Furthermore, neither GDP growth rate nor inflation<sup>rate was significantly</sup> related to FDI flows at the .05 level<sup>(although, again, GDP was significantly</sup> related to FDI). The relationship of<sup>FDI to economic growth and price stability may</sup> therefore be more complex than previously<sup>thought and involve lags over time and</sup> differences across countries that<sup>are difficult to capture without more complex</sup> econometric models.
23 Table 4-1. **GDP** and FDI For Eleven Host Countries, 1978-87 (annual average)

||1980 U.S<br>|. dollars (billions)|<br>Ra|nk|
|---|---|---|---|---|
|Country|DGEP||E|GDP|
|Argentina|0.25|49.9|6|7|
|Brazil|1.67|191.4|1|1|
|Colombia|0.24|29.4|7|8|
|Mexico|1.19|160.7|2|3|
|India|0.07|167.2|10|2|
|Indonesia|0.85|65.7|3|5|
|Korea, Rep. of|0.12|57.6|9|6|
|Malaysia|0.64|21.1|4|10|
|Thailand|0.18|28.6|8|9|
|Kenya|0.03|6.1|11|11|
|Nigeria|0.42|84.0|5|4|

Source: IFS; IMF data are not reported for India in Becsky, Lee, and Ordu (1990; table 4-2). Nevertheless, the OECD figures reported there and the IMF figures reported here are identical for thirteen of the eighteen years (1968-85) reported in table 4-2. For the eighteen year period, the IMF figures averaged 0.008 a year more than the OECD figures. Indonesia's figures are based on a composite of IMF and OECD figures for 1968-86; see table 5-3 Becsky, Lee, and Ordu (1990). Korea's figures are from the Finance Ministry for 1968-86; the 0. 12 reported here compares with the IFS average of 0.11 for 1968-87. See table 6-6 in Becsky, Lee, and Ordu (1990).

In table 4-2 the ratios of FDI flows to GDP for each of the eleven countries are presented for each five-year period from 1968 to 1987. Although those numbers are inevitably small, they nevertheless indicate the extent of the deviation in FDI flows for individual countries and time periods from what would be expected on the basis of the economic size of the host country alone. Malaysia, at one extreme, and India, at the other, are notable for the extent to which their FDI-GDP ratios differ from the mean of 0.4 percent for the group over the twenty-year period. Malaysia's FDI inflows were consistently far above and India's far below what would be expected solely on the basis of their economic size. Many countries exhibit stability in the relative sizes of their ratios over time, but others experienced significant changes in their ratios over the twenty-year period. Kenya's and Nigeria's ratios, in particular, were both quite high for the 1968-72 period before declining, while Brazil's decreased and Colombia's increased significantly by the 1983-1987 period. The ratio for Korea was surprisingly low throughout the twenty-year period, as FDI increases barely kept pace with GDP growth. Following Japan's example, Korea discouraged FDI in manufacturing sector until the 1980s.
24 There are, of course, important factors<sup>in addition to host-country</sup> economic size that affect FDI flows. The<sup>balance of this chapter considers the</sup> role of additional economic factors and the general<sup>political environment of the</sup> host country as influences on FDI flows.<sup>The next chapter considers more</sup> specifically and narrowly the FDI policies<sup>of the host countries, and chapter 6</sup> considers the policies of home governments and international institutions as they bear directly on FDI in developing countries.

Table 4-2. Ratio of FDI Flows to GDP for Eleven<sup>Host Countries</sup> (percent)

|Country|1968-72|1I271ZZ|1928-82|1283-87|
|---|---|---|---|---|
|Argentina|0.1|0.1|1.0|0.8<br>|
|Brazil|1.0|1.3|1.0|0.4|
|Colombia|0.6|0.2|0.5|1.6|
|Mexico|0.8|0.7|0.9|0.5|
|India'|0.0|0.0|0.0|0.0|
|Indonesia|1.5|2.4|1.4|0.3|
|Korea|0.2|0.2|0.2|0.2|
|Malaysia|2.1|3.6|4.0|2.3|
|Thailand|0.9|0.7|0.5|0.6|
|Kenya|1.0|0.6|0.6|0.2|
|Nigeria|1.1|0.7|0.2|0.3|

a. India varied between 0.01 and 0.04 percent. Sources: See table 4-1.

# Economic Policies

A broad spectrum of host-country economic policies<sup>is inevitably of concern</sup> to foreign direct investors. All of the usual<sup>domestic economic policies that</sup> affect businesspeople's calculations of expected<sup>returns and risk pertain, but</sup> foreign direct investors are also concerned<sup>about host countries' international</sup> economic policies. Perhaps above all<sup>else, investors desire as much stability</sup> in economic policy as is practicable,<sup>but they also want economic adjustment</sup> processes to be allowed to operate with<sup>minimal government intervention.</sup> Thus, for instance, they want exchange<sup>rates and interest rates to be</sup> allowed to adjust to changing inflation rates.<sup>If exchange rates, in particular,</sup> are not allowed to reflect cross-national differences in inflation rates, foreign direct investors (as well as other businesses)<sup>are exposed to price distortions</sup> in their costs and revenues that can<sup>threaten their long-run competitive</sup> position. Althcough investors prefer stable exchange rates in the short<sup>run, then'</sup> do not want exchange rates to be inflexible<sup>and insensitive to basic price and</sup> income forces in the long run.
25 Investors may enjoy the benefits of low subsidized interest rates for their own projects, but they want interest rates in general to reflect inflation rates, and thus be positive in real terms. Otherwise, low domestic investment rates and capital flight can contribute to a deteriorating domestic economy and balance of payments position.

In order to gain a more refined understanding of the effects of hostcountry economic conditions and policies on PDI, further distinctions about the different kinds of FDI projects need to be made. In both the manufacturing and services sectors, although market size is a function of national incomes, changes in the distribution of income among regions within a country and among other socioeconomic groups can also affect the attractiveness of a host country's market. A less unequally distributed national income, and thus an increasingly large middle-income group, for instance, or migration irom rural to urban areas, can make a given market more attractive for some products.

For all manufacturing FDI projects--and especially those based on an efficiency-seeking strategy--the effects of host-country economic conditions on the firms' costs are a central concern for investors.16 Thus, inflation rates, foreign exchange rates, wage rates, national savings and investment rates, and all other economic conditions that bear on a project's costs are potentially important. Policies leading to import protection and export promotion also matter for FDI. The host-country corporate tax level, for instance, was found to be significantly correlated with manufacturing FDI flows to forty-one developing countries during 1966-70 (Root and Ahmed 1978). In recent years cost considerations have become particularly important as firms have restructured and further diversified and integrated their production operations internationally in response to competitive pressures.

In service industries, particularly in the past, many FDI projects were undertaken by corporations that followed their home-country corporate manufacturing clients into developing countries. Thus, direct investments were made in financial services, accounting services, and consulting services so that corporations could better serve (and thus retain the business of) their corporate customers as these customers undertook their own FDI projects. To the extent that the business of the corporate clients of the service industries depends on host-country economic conditions, the service corporations' interests are also dependent (indirectly) on those same conditions. This indirect dependence of the service industries on host-country economic conditions will continue in the future because many service indutstry FDI projects are still primarily designed to serve home-country based corporate clients. In addition, however, many service industry FDI projects in the future will serve the local host-country market so that host-country economic conditions will become more directly relevant. The prevalence of this occurrence will depend on the extent to which the service sector is made more open to FDI through multilateral and bilateral negotiations.
26 For resource-seeking investments, of course, the host-country endowment in the relevant natural resource is the most<sup>important feature attracting investors,</sup> although even in those instances investors<sup>are not likely to be oblivious to</sup> economic conditions in the host country if<sup>there is more than one potential site</sup> for their extractive operations. As FDI<sup>in the primary mineral and agricultural</sup> sectors has declined in relative importance,<sup>and FDI in the manufacturing and</sup> services sectors has increased in relative<sup>importance, host country economic</sup> conditions have become more significant.

The precise effects of economic conditions, furthermore, greatly depend on the particular features of specific FDI projects.<sup>A project that imports a high</sup> proportion of its raw materials and components<sup>and exports a high proportion of</sup> its products will obviously experience a relatively<sup>strong and direct impact from</sup> changes in foreign exchange rates. A project<sup>that has a high proportion of its</sup> production costs in local labor and sells<sup>a high proportion of its products in</sup> the local market will be affected strongly<sup>by wage and price controls. In any</sup> case, the relationship between exchange<sup>rate changes and cross-national</sup> differentials in inflation rates can,<sup>of course, be crucial.</sup> Economic conditions in neighlboring countries can also be important- -as the experience of Malaysia demonstrates. During<sup>the period from the late 1960s until</sup> the early 1980s, when FDI in Malaysia<sup>increased substantially, the economic</sup> growth in nearby Singapore and Hong Kong<sup>was a major driving force. By the mid-</sup> 1980s, approximately half of the FDI<sup>in Malaysia had come from these two</sup> neighboring economies. In addition to the<sup>relatively rapid economic expansion</sup> in Singapore and Hong Kong that accounted<sup>for the FDI flows into Malaysia,</sup> however, the relatively low wage rates **itl** Malaysia compared with the other two economies played an important role. This<sup>combination of growth in neighboring</sup> countries and low wages in Malaysia<sup>also accounts for many of the Japanese,</sup> British, and American investments in manufacturing.<sup>(In addition to the surge</sup> in manufacturing FDI in Malaysia, there<sup>have been Japanese and American</sup> investments in oil and liquefied natural<sup>gas in recent years, and there is a</sup> continuing British presence in agriculture.)

# Political Stabilitv

Investors' costs and revenues are not only<sup>affected by economic conditions,</sup> they are also dependent on political<sup>conditions, including the stability of the</sup> political system. Among the eleven selected<sup>countries, the effects of political</sup> instability on FDI can be demonstrated in<sup>two ways. First, and most important,</sup> there are countries such as Argentina, whose<sup>history has been marked by chronic</sup> political instability that deterred many<sup>investors from undertaking projects.</sup> Particularly in the case of Argentina,<sup>the changes in regimes (which have</sup> sometimes occurred through irregular<sup>means and have sometimes entailed major</sup> shifts in government ideology) have<sup>been accompanied by instability in FDI</sup> regulations and macroeconomic policy (Becsky,<sup>Lee, and Ordu 1990, Brewer 1986;</sup> Brewer 1985).
27 Second, brief periods of government instability can cause interruptions in FDI flows as investors "wait for the political dust to settle.' For instance, in the late 1970s, Kenya, which is widely perceived as a relatively stable political environment for FDI, suffered a 'hiatus of FDI that resulted from the death of Jomo Kenyatta [and] did not end until late 1979, following Arap Moils election as president" (Becsky, Lee, and Ordu 1990, chapter 7). Even quite brief and transient interludes of instability can lead to cancellations of FDI projects, not merely their deferral, because investors sometimes react strongly to the slightest hint of instability (Brewer, David, and Lim 1985, p.217). A different kind of instability--civil war--led to declines in FDI in Nigeria in the 1960s.

Several studies have tried to determine empirically the role of instability in investors' decisions about FDI projecta on the basis of systematically collected data. The studies have generally been of two kinds--those based on executives' answers to survey questions in interviews and questionnaires and those based on events and FDI data. The studies based on surveys consistently find that executives consider perceived host-country instability to be a major deterrent in FDI project location decisions (for example, Green 1972; Root 1968; Frank 1980, especially pp.111-12).

Other studies have also found significant effects of political instability on FDI flows. For instance, a study of foreign direct investments in manufacturing in twenty-four countries, including eleven developing countries, over the period from 1954 to 1975 by multinational corporations based in the United States was conducted to determine the relationship between FDI and political conflict (Nigh 1985). For the developing countries in particular, the study found that FDI flows were related to indicators of internal conflict such as riots and civil war; this was true for lags of zero to two years.

To the extent that political instability affects investors' perceptions of host-country conditions, and thus increases their uncertainties about the future environment for FDI, political instability can be a serious deterrent to FDI inflows. In addition, some forms of political instability can lead to instability in specific government policies that directly affect FDI projects. There is some evidence, however, that in this respect host-country political instability may not be as problematic as many investors believe. A study of governmental instability in developing countries found it to be only weakly related to instability in their restrictions on international funds transfers associated with FDI projects, and less so than among developed countries (Brewer 1983).

Instability in host countries therefore does not necessarily create an intolerable environment for successful FDI projects. There are many combinations of stability and instability, which vary considerably in how problematic they are for FDI. Some instances of host-country instability can be detrimental to the interests of FDI projects; other instances of host-country instability have relatively little bearing on FDI projects.

Another point that investors should keep in mind in their assumptions about
28 political instability is that developing countries are not uniformly less stable than industrial countries. Among the industrial countries, both France and Italy, for instance, have had periods of relatively frequent changes in governments. The U.S. political system has also exhibited elements of instability, with numerous assassinations and attempted assassinations of presidents and other national political figures since the mid-1960s. During the past decade there have also been unprecedented and largely unanticipated changes in the regulatory and tax environments affecting business. Finally, there has been a significant shift in the U.S. trade balance, as well as the international investment position itself, and accompanying shifts in the sentiments of the public and political leaders concerning trade and FDI policies. Such changes are hardly systemic revolutions, but they do create uncertainties in the business environment and complicate business planning and operations. Political instability, in short, is not unique to developing countries.

Some empirically based comparisons between developing countries and industrial countries challenge conventional perceptions of relative degrees of instability. In particular, fiscal policy was actually found to be less stable in nineteen industrial countries as a group than in nineteen large developing countries (Yu 1987). The relationship between the instability of a government and instability of fiscal policy, furthermore, has been found to be greater among industrial countries than among developing countries (Brewer 1985). Although these findings are restricted in their policy coverage and in the forms of instability included, the broad country coverage and redundancy in the findings tend to give them credence.

These findings suggest that stereotypic thinking about political instability in developing countries may be a major impediment to FDI. If potential investors' assessments of host-country stability were more speci£ic and factual, they might find that a given prospective investment climate is more hospitable than first imagined. In sum, investors should be careful to be discrimirnating and not unduly skittish in their reactions to perceived instability in developing countries. They should not allow dramatic episodes -- such as those in Cuba in the late 1950s, Iran in the late 1970s, or in China in the late 1980s--to distort their perceptions of the investment climate for FDI projects in individual countries. Another area of potential distortion in investors' perceptions is that of more specific "political" or noncommercial risks, including expropriation, which is discussed in the next chapter.
29

# Chapter 5

# Host-Country FDI Restrictions and Incentives

As developing countries have passed through periods of changing attitudes toward FDI there has always been a widespread ambivalence--a positive interest in its potential role in development and a negative view of foreign control over the local economy. During the 1980s, however, there was a widespread shift in the balance toward a generally more positive attitude, particularly in reaction to the external debt payment problems caused by increased borrowing from commercial banks in the 1970s. The debt crisis led many countries to ease their restrictions on FDI and put increased emphasis on export-oriented FDI projects.

These shifting sentiments and policies concerning FDI have varied among host countries. Brazil, for instance, adopted a generally positive policy throughout the 1970s, when many other developing countries were still hostile toward FDI, but in the 1980s Brazil increased its sectoral FDI restrictions just as other countries were liberalizing theirs. A few countries--such as India (with a negative attitude) and Kenya (with a positive view)--have been relatively constant in their attitudes toward FDI for many years, with only marginal and occasional shifts.

One particular overall trend that has been clear over the past decade is the decline in instances of expropriation. For some countries the fear of foreign control during the period of early independence resulted in numerous expropriations. The incidence of expropriations, however, peaked in 1975 and has declined dramatically since then, as documented in table 5-1. Although expropriation has thus waned as a problem for investors, host countries have adopted diverse restrictions and incentives in an effort to influence the inflow of FDI. These FDI policy components are described below in summary form for host countries in general, the policy tendencies of the eleven selected host countries are then examined and three recent examples of major FDI policy cha ae are considered.
30 Table 5-1. _Trds_ in the Incideae of Kxpeliatlm. 1960-1985

|Year|Number of Acta<br>of expropriation|Number ofExpropriating<br>countries|
|---|---|---|
|1960|6|5|
|1961|a|5|
|1962|8|5|
|1963|11|7|
|1964|22|10|
|1965|14|11|
|1966|5|3|
|1967|25|8|
|1968|13|a|
|1969|24|16|
|1970|48|18|
|1971|51|20|
|1972|56|30|
|1973|30|20|
|1974|68|29|
|1975|83|28|
|1976|40|14|
|1977|15|13|
|1978|15|8|
|1979|17|13|
|1980|5|5|
|1981|4|2|
|1982|1|1|
|1983|3|3|
|1984|1|1|
|1985|1|1|

Dgts: An act of expropriation is defined in the sources as the expropriation by one country in one year of firms in one industry.

Sorce: Kobrin (1984), table 1; and Minor (1988), table 1.

# Summary of Policile

Host-country policies toward FDI can include a broad range of incentives and disincentives, which can be classified according to whether they affect a firm's revenues, input costs, or components of the value added. Within each of these categories, the effect of each policy instrument on the investor's return on equity can be identified as either positive or negative--possibilities that are summarized in table 5-2. The list in the table is so exhaustive and detailed, that it is unnecessary to comment on it at length. It can be mentioned, however, that a host government can easily create a complex combination of these elements that is at once both enticing and restrictive for investors and offers many opportunities for obfuscation and change on the part of government officials. As we shall note below, it is not only the degree of hospitality toward FDI embodied in such policies, but also their transparency and stability that are important to investors.
31 Table 5-2. Types of FDI Policy Incentives and Disincentives

# Incentives/disincentives

# Effect on after-tax return on owner's equity

# Affe-cting Revenues

Tariffs + Differential sales/excise tax + or - Export taxes/subsidies (including income tax credits) + or - Quotas + Export minimums Price controls (or relief from) + or - Multiple exchange rates + or - General overvaluation of currency Government procurement preference + Production/capacity controls + Guarantees against government competition + Prior import deposits + Transfer price administration

# ffectinInuts

Tariffs Differential sales taxes (and exemptions therefrom) + or - Export taxes/subsidies (including utilities) + or - Quotas Price controls + Multiple exchange rates + or - Subsidy or tax for publicsector suppliers + or - Domestic-content requirements Prior import deposits Transfer price administration Limits on royalties, fees Multiple deductions for tax purposes + Cash or in-kind grants for R&D +
32

# Affecting Comnonents o-f.Value-Added

|Capital||
|---|---|
|Direct subsidy|+|
|Cost of capital goods||
|Tariff/sales tax exemption on imported/<br>domestic equipment|+|
|Prior import deposits<br>Local-content requirement for capital||
|equipment||
|Limits on use of used equipment||
|Subsidized buildings|+|
|Subsidized cost of transportation|+|

# Cost of Debt

|Subsidized loafs|+|
|---|---|
|Loan guarantees|+|
|Covering of foreign exchange risks on||
|foreign loans|+|
|Priority access (including limitations on<br>foreign firms)|+or|
|of Equity<br>Subsidized equity through public invest-<br>ment agencies|+|
|Exemption from capital gains tcexes/||
|registration taxes|+|
|Dividend<br>tax/waiver|+ or-|
|Guarantee against expropriation or||
|differential treatment|+|
|Limitations on debt-equity ratio||
|Controls/taxes on remitted dividends||
|Minimum financial-in-kind<br>ratio||

# Cost of Equity

# CorRorate tax

|Tax holiday/reductions|+|
|---|---|
|Accelerated depreciation|+|
|Special deductions and valuation practices||
|(inflation adjustment, multiple plant<br>consolidation)|+|
|Tax sparing and double-taxation||
|agreements|+|
|Loss-carry-forward<br>provision|+or-|
|Contractual stabilization of rates|+|
33

# LAkQ

Wage subsidies (includiiig indirect, that is, multiple deductions of wages for tax computations/reduction of taxes on labor) + Training grants + Minimum wage Relaxation of industrial relations laws + Local labor requirements Cash subsidy for purchase/rental + Exemption/rebate of taxes on land +

# Not Classified

Limitations on foreign ownership Free-trade zones General preinvestment assistance Counrtrtrade requirements Po ., , exchange balancing requirements Source: Guisinger and Associates (1985).

These FDI policy instruments are evident in a variety of combinations among the eleven selected host countries. Brazil, for<sup>instance, continues to be</sup> essentially hospitable toward foreign investors<sup>but retains restrictions in some</sup> industries (petrochemicals, telecommunications, and informatics). Moreover, there are joint venture requirements in<sup>some sectors, and there have been</sup> restrictions on borrowing and international remittances.

Argentina's policies continue to exhibit<sup>the instability that has been</sup> their hallmark since the late 1960s. Yet, except<sup>for the 1973-76 period,</sup> Argentina has generally welcomed FDI and adopted<sup>amoderately liberal FDI policy</sup> framework. In 1989 it took ma'or steps<sup>to attract more foreign capital,</sup> especially by liberalizing its petroleum<sup>sector. During the 1980s, as a result</sup> of the debt crisis, there were periodic restrictions on profit<sup>and capital</sup> transfers.

Colombia has adopted an unusually strong sectoral<sup>orientation in its FDI</sup> policies. As a member of the Andean Group<sup>since 1970, Colombia adopted FDI</sup> policies with a tilt toward control rather than<sup>openness. Although its policies</sup> gradually were liberalized in the 1980s, they<sup>still favor extractive projects,</sup> particularly oil.
34 Mexico announced a major liberalization of its FDI policy in May 1989. Prior to that policy change, Mexico exhibited a strong tendency toward restricting foreign ownership, especially in the natural resources industries. The Mexicanization program nevertheless allowed and--even encouraged-substantial FDI in Mexico, particularly in manufacturing. Although Mexico has generally adopted liberal capital and foreign exchange controls, there were instances in the 1980s when restrictions were imposed on FDI-related remittances. Mexican FDI regulations also tend to be complex.

Kenya's FDI policy has included relatively liberal elements and generous incentives that have been available in selected cases. It has also implemented a comprehensive screening system, applied an extensive Africanization program, excluded FDI from several sectors, and imposed foreign exchange controls and borrowing limits on investors. Kenya's policy is presently marked by ambivalence in its basic direction and administrative details.

Nigeria has recently instituted a wide-ranging liberalization of its FDI regulations. The main outlines include a streamlining of the regulatory environment, a one-stop agency concept, simplification and enlargement of incentives, and privatization of parastatals, reversing pr'or foreign ownership restrictions. In the past, however, Nigerian pe'icy onsistently involved considerable complexity, uncertainty, and delays in the administrative process--and only marginal incentives. (See the section below on policy change for further details on Nigeria's policy.) India maintains a restrictive FDI policy that discourages majority foreign ownership. Its approach to the regulation of FDI depends to an unusual degree on exchange controls, and there is a strong emphasis on technology transfer. Regulations are flexible depending on the degree of foreign and local ownership, with foreign ownership generally limited to 40 percent. There has been some liberalizatien of India's restrictions in recent years, but the overall FDI approach remains restrictive.

Indonesia's FDI policy regime has been marked by a mixture of both moderately liberal and restrictive elements, although on balance it has offered an increasingly hospitable climate and substaniial relaxation of restrictions on FDI in recent years. Its restrictions on capital repatriation and profit transfers have been minimal, and fiscal incentives are supportive, but not as abundant as they used to be. At the same time there have been some limitations on foreign owned projects in agriculture, manufacturing, and services (these were significantly relaxed in 1989). In the energy sector, no foreign equity ownership is allowed, although other forms of foreign investment are permitted. Malays.a's FDI policy is conspicuous among the eleven countries i. its mixture of a liberal policy that reflects a positive attitude toward FDI and a restrictive policy that reveals a desire to control the ownership of business along domestic ethnic lines. The result is an FDI policy combining two alayers."17 The first layer, which was put in place during the 1957-71 period, included few limits or other regulations; instead, the emphasis was on incentives for export-oriented projects that used local raw materials and ethnic Malay
35 labor. A major shift occurred in 1971 with the establishment of the New Economic Policy (NEP), which was designed to foster ethnic Malay ownership of businesses within Malaysia--a measure that had important consequences for FDI. A distinction was made in the amount of foreign ownership allowed, depending on whether a project was import-substituting or export oriented. Thus, new importsubstituting FDI projects were required to have majority ownership by ethnic Malays at the outset, and any forei&u ownership was required to be phased out by 1990. Majority foreign ownership was still permitted in export-orienLed projects, but foreign ownership overall had to be reduced to 30 percent of total FDI stock by 1990. In 1986 these NEP ownership restrictions were relaxed, at least temporarily.

The regulatory framework for FDI in Thailand is relatively liberal, except that there are significant sectoral restrictions on FDI. Majority foreign ownership is not allowed in some manufacturing sectors and most service businesses. in sectors that are freely open to foreign investors, however, there is freedom of profit remittance and capital repatriation. In addition, Thailand's industrial policy includes a generous package of incentives that are equally available to foreign investors (in permitted industries) and domestic investors.

In Korea a liberal FDI policy regime has prevailed since 1984. Under the system in effect since then, foreign investment is allowed in most sectors, the percentage of foreign ownership is generally not limited, and capital and profits can be freely transferred. Prior to the liberalization measures in the early 1980s, however, there were extensive restrictions on FDI.

To assess the effects of these policies on FDI it is helpful to isolate several major dimensions of the policies.<sup>18</sup> One obvious dimension is the degree to which the host country is hospitable to FDI--a dimension that varies considerably both across countries and over time for any one country. In table 5-3 the eleven countries are listed with the degree of hospitality of their FDI polices during the two-and-a-half decades covered by the country studies, and then separately for the period since the early 1980s.

As examples of extreme opposites, Brazil, which has generally adopted hospitable FDI policies, has experienced disproportionately large amounts of FDI flows, while India nas been the recipient of disproportionately low levels of FDI as a result of its relat:vely inhospitable policies. The relationship between a hospitable policy and FDI flows, however, is only approximate; the overall attractiveness of a host country's FDI policies depends on other dimensions as well, particularly their transparency and their steadiness (see Becsky, Lee, and Ordu 1990 and Frank 1980).
36 Both transparency and steadiness are important because they affect the degree of uncertainty that investors face as they contemplate FDI projects. Because investors are sensitive to the estimated risks as well as the projected returns associated with investments and because they always face commercial risks associated with doing business in a country, any additional uncertainty about the prospects for a given investment created by a lack of transparency or stability in a host country's FDI policies can be a serious deterrent to investors' investment plans. A lack of transparency in FDI regulations and incentives makes investors' estimates of the costs associated with host FDI regulations more problematic; it also makes their estimates of the benefits associated with the host FDI incentives more difficult to calculate. Furthermore, it is often difficult to determine the extent to which formal versus informal rules are actually operative in a given country at a given time. Some countries, however, tend to be rather formal in their approach, while others rely much more on informal interpretations of the rules in their application to individual cases. A frequent result of the informal approach, however, is that there are so many exceptions to the rules that the rules become practically meaningless and there is ircreased uncertainty for investors. Nevertheless, if the exceptions are codified, the formal rules become overly complex and confusing to investors.
37 Table 5.3 Major Dimensions of Host Country FDI Policies

|Country|Steadiness|Transparency|Hospitality|
|---|---|---|---|
|Argentina|_-/-_|_+/+_|-/+|
|Brazil|+/+|+/+|+/+|
|Colombia|_-/-_|_--_|-/+|
|Mexico||_-/-_|_+/+_|
|India|+/+|_+/+_|_-/-_|
|Indonesia|+/+|+/+|+/+|
|Korea, Rep. of|_-/-_|+/+|-/+|
|Malaysia|_-/-_|_-/-_|_+/+_|
|Thailand|_-+_|_--_|_+/+_|
|Kenya||_-/-_|_+/+_|
|Nigeria|_-/-_|-/+|-/-|

wy.3te Sign before the slash refers to overall record of the past two-and-a-half decades. Sign after the slash refers to the period since the early 1980s.

Source: These are summary judgments based on the evidence in Becsky, Lee and Ordu (1990), as supplemented by codings by Thomas L. Brewer and Alovsius Ordu.

# Illustrative Recent Policy Changes

Investors, of course, find some policy changes to their liking, particularly changes that are comprehensive liberalizations of policy and are likely to remain in effect for an extended period of time; sue.. policy changes can have a significant effect on FDI flows. Comprehensive packages of liberalization of policy are often followed by significant increases in FDI, and comprehensive packages of increased restrictiveness are similarly often followed by dramatic declines in FDI. (Becsky, Lee, and Ordu 1990, contains detailed analyses of several instances; a few are highlighted here for brief illustrative purposes.) The correspondence between comprehensive FDI policy change and changes in FDI flows has been obvious in Korea. A generally liberal policy, including incentives for FDI, was in place from 1960 to 1973. After an initial period when FDI remained at modest levels, it increased substantially by the early 1970s. (An increase in restrictiveness in 1965 was largely directed at Japanese investors and not effectively implemented in any case.) In 1°73 more extensive regulations were imposed, including major restrictions on ownership; foreign ownership was generally limited to 50 percent, minimum investment levels were established, and investments that competed with domestic Korean firms were rarely approved. As a result annual FDI flows declined during the mid and late 1970s.
38 FDI policy reversal embodied in a series of measures taken in 1980-84 subsequently reversed the trend in FDI flows. These measures greatly simplified and liberalized FDI policies. This reversal in policy was a response to the cumulative effects of the oil price increases of the middle and late 1970s--including negative growth in GDP isi 1980, the first such decline in more than twenty years. The change in FDI policy was undertaken not merely for short-term balance of payments reasons, but also as part of a more comprehensive shift in policy that was designed to increase the competitiveness of Korean industry over the long term.<sup>19</sup> In September 1t980 an initial list of measures to encourage FDI was introduced. They increased the percentage of foreign ownership allowed in some projects, lowered the minimum size of investment, and allowed foreign participation in a broader range of projects. In July 1981 additional guidelines further reduced the restrictions. In September 1983 the government announced major simplifications in the FDI regulations, as well as the introduction of a "negative list" which allowed investments unless they were on the prohibited list (rather than the previous reverse practice of allowing only investments that were on the approved list), a change that was a significant liberalization, not merely a semantic or administrative gimmick. The new regulations became effective on July 1, 1984.

Pecent FDI policy changes in Nigeria are also an example of the kind of comprehensive policy change that investors prefer. The effect on FDI flows is not yet apparent, however, because the major changes embodied in its industrial policy were only published in 1988.20 Adopted as a consequence of the Structural Adjustment Program of 1986, the new Nigerian industrial policy represents a significant departure from previous FDI policy. The new approach attempts to create an FDI policy framework that is much simpler and clearer than ir. the past. In institutional terms, Decree Number 36 establishes an Industrial Development Coordination Committee (IDCC), which has the authority to approve preinvestment agreements, fiscal incentives, employment permits for foreigners, and foreign capital imports, as we'll as to provide policy advice to the federal government. The IDCC is a "one-stop" agency for FDI; unless an investor is informed otherwise, it can assume its application has been approved sixty days after submission.

The shift in Nigeria's approach to FDI policy includes changes in the substance of policy in addition to streamlining the FDI approval process. Although there are still significant restrictions on foreign ownership, the revisions of the Nigerian Enterprises Promotion Decree create a simpler policy and allow a much wider scope for new foreign investments. There is now a single schedule of restricted industries to replace the previous three schedules. The Privatization and Commercialization Decree of 1988 does not set any limits on foreign ownership of the state economic enterprises earmarked for complete or partial privatization. This privatization program is complemented by a new debt-equity conversion program potentially totalling $8 billion (28 percent of the external debt).
39 The new FDI policy also includes an extensive array of new fiscal incentives, including a 100 percent tax holiday for seven years, plus an additional 5 percent depreciation beyond the initial capital depreciation allowance for investments in disadvantaged areas. There are also tax reductions for the construction of infrastructure, research and development activities in Nigeria, and in-plant training programs.

FDI policy changes announced by Mexico in May 1989 also appear to be relatively comprehensive and should alter investors' perceptions of the investment climate. The intention of the new policy is to facilitate foreign investment in most sectors by making the FDI regulations simpler and more transparent and by allowing majority foreign ownership. Under the new regulations, foreign investment up to $100 million and majority ownership up to 100 percent will be allowed if seven explicit tests are met. In addition to the $100 million limit, the criteria are that financing of the project be entirely external; that the initial outlay be at least 20 percent of the total project cost; that the project achieve foreign exchange self-sufficiency within three years; that technology in keeping with environmental regulations be used; that the project be located outside the Valley of Mexico, Monterrey, and Guadalajara; and that the project create permanent employment and provide training for Mexicans. Any project meeting these tests will be approved.

Most sectors of the economy will come under these new regulations and thus will be more open to foreign investment. Some industries, however, such as petrochemicals and automotive parts, will be subject to different regulations. Special trust funds providing for majority foreign ownership for twenty years can be established in those industries. This plan is an application to industrial FDI projects of a program that has been used previously by the Mexican government for FDI projects in tourism--a plan that aliows an additional thirty-year extension before expiration. After the expiration of the trust fund period the foreign investor must become a minority shareholder, so the scheme for these selected industries is in essence a program of deferred Mexicanization (Financial Times, May 25, 1989,p.8).

In sum, the degree of hospitality extended to foreign direct investors is only one of many important features affecting the attractiveness of host FDI policies. The transparency of FDI regulations is also important, because investors need to know in advance how the host-country regulations will be applied to their projects. If there is a high degree of variability in the interpretation of the r g,ulations, or if it is necessary to obtain the approval of multiple host-goveriment agencies (which may disagree among themselves), an otherwise hospitable host-country environment will become unattractive. Furthermore, steadiness in the FDI regulations is important to investors. Because foreign direct investors already face the normal commercial risks of doing business, plus the additional uncertainties of being foreign to the host country, constantly changing FDI regulations can be a significant deterrent to FDI flows. Consequently, host countries that exhibit not only hospitable but also transparent and stable policies provide investors with unusually attractive conditions for FDI.
40

# Debt-EquitX SwaDs

In recent years debt-equity swap programs have been widely used as an additional incentive in FDI policies. Because the host government buys the debt instruments from the investor at a smaller discount than the investor receives from the commercial bank, the host government is subsidizing the investor's equity investment. Host governments commonly restrict the investment opportunities to selected sectors, and they also often restrict investors' profit remittances. After a slow start in the mid-1980s, debt-equity swaps initiated by developing countries had reached $8.9 billion by 1988 (World Bank, Quarterly Review of Financial Flows to Developing Countries, March 1989). In addition, there were informal conversions directly between creditors and debtors without formal government involvement, as well as exit bonds and other types of debt reduction programs, so the total magnitude of debt conversion transactions in that year amounted to $21.1 billion.

These transactions have been highly concentrated, with more than 90 percent in four Latin American countries: Brazil, Mexico, Chile, and Argentina. Among the other eleven selected countries, however, the recently developed program of Nigeria has attracted much interest. Asian trading firms already in Nigeria have been particularly active in using debt-equity conversions as a means of diversifying their portfolios into additional sectors. At the first three auctions between November 1988 and February 1989, limits of $40 million, $30 million, and $25 million were established to constrain the domestic inflationary impact of the conversions. Over the three auctions bids totalling $334.4 million were received, at discounts ranging from 36 to 58 percent.

Although these and other debt-equity swap programs may offer individual investors highly attractive opportunities for FDI projects, their ability to stimulate additional new investment that wou'd not otherwise have taken place and their monetary and balance of payments consequxences pose a variety of issues. In any case, such programs are likely to remain important, if specialized, features of the FDI policy framework of many countries for the foreseeable future.
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# Chapter 6

# Policies of Home Governments and International In3titutions

Home governments and international institutions have adopted a variety of policies designed to facilitate the flow of FDI to developing countries. They include guarantees for investors against noncommercial ("political") risks, project opportunity information services, and project finance assistance for investors, policy advice for host governments, dispute settlement services, and equity participation in projects. In addition, there are numerous data banks and other information services that are available for private sector investors as well as public sector organizations.

Although not directly focused on FDI, grant and lending programs of international institutions and developed countries that provide support for stabilization, structural adjustment, and privatization policies in host developing countries have important consequences for the macroeconomic and sectoral environment of FDI projects. Given the importance of these host-country conditions, as emphasized in chapter 4, such policies should not be neglected in any comprehensive analysis of the role of home governments and international institutions in facilitating FDI flows to developing countries. It is such a broad and complex topic in itself, however, that it cannot be discussed in any detail here. Rather, this chapter will focus on policies that are more directly concerned with FDI.

# Guarantees

Numerous multilateral and bilateral treaties and other agreements have been developed to establish a legal framework for FDI guarantee programs and other policies. The latest and perhaps most significant is the establishment of tbe Multilateral Investment Guarantee Agency (MIGA) within the World Bank group. MIGA's programs of investment guarantees and other services are intended to supplement the activities of other international institutions and national governments. The creation of MIGA within the World Bank group marks the beginning of a new era in the public policy framework affecting FDI in developing countries. Despite the long negotiations required to draft its convention and obtain sufficient signatories to bring it into force, that a new international agency, created with the cooperation of both the developing and developed countries, is in itself an indication of a change in the climate of official opinion concerning FDI.

Since it has only recently become operational, MIGA's programs are still in the formative stage. It is likely to evolve into a participant in three broad areas of policy concerning FDI. The first and most obvious is to provide guarantees against noncommercial risks. Its role in this activity is designed to supplement the existing national home government programs and the programs of private "political risk" insurers--a role that has two components. The first component is based on MIGA's authority to issue guarantees on its own behalf for individual projects, which will tend to be projects in host-countries that are
42 not covered by the investors' home-country guarantee programs or projects that are otherwise not eligible for home-country coverage. The second component is based on MIGA's authority to issue guarantees for projects that are sponsored by home-government agencies, which will enable the home-government agencies to diversify their portfolios of guarantees.

Most developed countries have long had government agencies that issue guarantees agains:.. noncommercial risks. Like MIGA, many of these national programs can protect investors against losses from expropriation, restrictions on profit remittances and other funds transfers, war and other forms of violence, and in some instances, contract repudiation as well. Although these home-government investment guarantee schemes are well known, they are not widely used. In the early 1980s only about 9 percent of the total FDI stock in developing countries from OECD countries was covered by their home country investment guarantee programs, and only about 20 percent of the flows at that time were being covered (Shihata 1982, p.12). There have been, however, large variations in the extent of coverage among countries--with Japan at one extreme (over 50 percent coverage) and several West European countries at the other (less than 5 percent coverage). The generally low levels can be attributed to a variety of factors, including restrictions on eligibility based on national interest considerations, limited financial resources of guarantee agencies, and concerns about portfolio diversification.

For companies from the U.S. this issue is investigated in more detail in a recent study that surveyed multinational corporations concerning their investment decisions in developing countries (Wallace, forthcoming). Among the cooperations covered, roughly one-quarter were insured one way or the other. Most of the companies were at least partially protected under the scheme of the U.S. government's Overseas Private Investment Corporation (OPIC), and another 8 percent were thinking about becoming insured by OPIC. MIGA, although just established, received much attention, with 13 percent of the companies either considering or already committed to MICA. Some companies had participated in an insurance scheme in the past and later withdrew; they had decided to reduce their foreign investment to a level low enough to make risk insurance obsolete. Most companies that are not insured against political risk considered this issue critical to their investment decision, while only about 60 percent of the insured companies consider this issue to be critical. Thus, there are two kinds of companies when risk behavior is considered: those which perceive the reduced political risk (for example, the declining number of expropriations) ..orrectly, and therefore feel less of a need for insurance, and those which do not get involved in more detailed risk considerations at all and avoid high risk regions. 21 There are also a small number of private political risk insurers. Because these are private organizations, they have great flexibility in the kinds of coverage and projects and the host-country locations they chocse to cover compared with home government agencies. Their fees are also higher and the duration of their coverage shorter than those of the government programs.
43

# Other ISSues

Although HIGA's guarantee program received the most attention during its formation, its informational and advisory services for governments and investors, as well as its potential to become a key international institutional forum for FDI policymaking are also central to its mission.

MIGA's informational and advisory services for investors will supplement an array of programs already in existence under the auspices of national governments and international organizations. For instance, the United Nations Industrial Development Organization has an investment promotion office in New York. As an example of a home government investor information service, OPIC maintains an Opportunity Bank listing information about projects for which host governments seek investors.

In addition to the information activities of such FDI investment guarantee agencies, there are also other agencies that can provide prospective investors with information about projects and the investment climate in developing countries. In the U.S. these include the Commerce Department, the Agriculture Department, the Trade and Development Program of the U.S. International Development Cooperation Agency, and other agencies as well. Furthermore, many host governments have investment promotion offices in New York and other cities to supplement the promotional activities of their own embassies and ministries. These diverse governmental sources and the numerous commercial and other nongovernmental sources provide investors with ample and readily available sources of information that they might seek for planning and operating particular proj ects. 22 In addition, many home governments provide project finance assistance through programs of loans to investors, loan guarantees, and equity participation. The funding for these programs is often modest, but their marginal contribution to individual projects can nevertheless be significant. A study of six such programs found that most of them made annual commitments to corporations totaling approximately $100-$800 million each during FY1983 (Ghadar Associates 1985). The study included agencies of France, the United Kingdom, the Federal Republic of Germany, the Netherlands, and the European Community. Among international agencies, the project finance activities of the International Finance Corporation (IFC) are also well known.

The existing array of home government and international institutions designed to facilitate FDI in developing countries is comprehensive. Nevertheless, there will always be questions about the "additionality" of these programs, that is, the additional amount of FDI that is made because of these programs that would not otherwise be undertaken. The evidence indicates that these programs do have an effect on particular projects in rather direct ways. For instance, a study of the additionality of the programs of OPIC concluded that 25 percent to 82 percent of the investments covered by OPIC would not have been undertaken without that coverage (Arthur Young and Company 1982). On the basis of an extrapolation of those findings for OPIC and depending on the assumptions about the capitalization levels and substitution levels for MIGA's program, MIGA's guarantee program could stimulate annual additional FDI of several hundred million dollars a year (see Moran 1986).
44 The most important element of these programs, however, may be their effects on the general perspectives and policies of investors and host countries. As far as host governments are concerned, the effect of the international institutions, in particular, includes pointing the direction toward new policies and providing policy reform assistance. In this way programs can contribute to the development of a more favorable host-country investment climate. For investors, the active interest of international institutions in projects ard their more general educational and informational function can alter investors' .erceptions of the host-country investment climate, and thus facilitate FDI.
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# Chapter 7

# Outlook for the Future

The eleven selected host countries present a wide range of prospects for FDI and illustrate the diverse array of factors that influence those prospects. Comprehensive recent changes in FDI policy and macroeconomic policy in Mexico and Nigeria offer investors the prospect of significantly more attractive investment climates, although concern about future economic stability in Mexico and political stability in Nigeria could still hinder investment. The net result, however, is that average annual FDI flows are likely to increase for those two countries over the next five years.

In Brazil significant FDI sectoral restrictions and economic instability constrain FDI, but a generally hospitable climate toward FDI prevails, and in the long term Brazil's market size will continue to be an attraction for FDI. The net effect of these conflicting forces is likely to be modest growth in FDI flows over the next five years. In contrast, the recent political changes in Argentina will create additional uncertainties for prospective foreign investors, who will likely adopt a wait-and-see posture for a year or two as they assess the investment climate, and thus contribute to declir.es in FDI flows.

The liberalization of FDI policies by Korea, in combination with economic stability, is likely to encourage continued increases in annual FDI inflows. In Indonesia, Malaysia, Thailand, and Kenya, the absence of any dramatic change in the mixture of forces affecting FDI flows suggests average anrual investment over the next five years at similar or slightly higher levels than during the past five years.

Among the eleven selected countries the greatest potential for increased FDI is in India. Given its market size and relative political stability, the basic economic and political conditions offer foreign investors an attractive environment. Yet, compared with the other ten countries, the ratio of FDI to GDr is by far the lowest in India. If the ratio of FDI flows to GDP for India reached the mean levels of the other ten countries for the 1983-87 period, there would be more than a twentyfold increase over the levels during the comparable period for India. There is already a stock of FDI in place in India, and it could serve as a basis for additional FDI. There is, furthermore, a considerable degree of diversity in both the number of source countries represented and the sectoral distribution. For India to attract FDI flows, liberalization policies would have to be adopted.

# Global Changes

Aggregate FDI flows to all developing countries are likely to average about SDR15 billion a year in the early 1990s. They are not likely to exceed SDR20 billion per year before 1993. The sectoral prospects for FDI vary considerably for minerals, agriculture, manufacturing, and services--both because of variations in the economic forces that drive FDI and because host-country FDI policy profiles are likely to continue to differ acrosb sectors. For the
46 services sector, for instance, increasing real incomes in middle- and upper-middle-income developing countries will increase market size, and thus their attractiveness as locations for FDI in services. At the same time, however, a strong tradition of restrictiveness in services trade and investment policies is likely to constrain FDI.

The policies of the developed countries are not likely to yield significant increases in the total magnitudes of FDI flows to developing countries within the next three years unless economic reforms in many developing countries improve investment climate substantially. The developed countries' programs to promote FDI in developing countries through guarantees against noncommercial risks and other means have been in place for many years. Even if there were major increases in these promotional efforts in the next year or two--which is unlikely--there would be a lag of several years before they had much effect on FD! flows.

The implementation of the European Community's (EC) 1992 program of further reductions in barriers to intra-regional trade and investment is already having an impact on FDI patterns. Thus far, the most important effect is that corporations based in the United States and Japan have been expanding inside the EC to serve the larger European market and to protect themselves from the effects of the more restrictive external trade barriers. To the extent that their increased FDI activities in Europe use their scarce financial, managerial, and other resources, these corporations' FDI activities in developing countries will be limited. This would be particularly the case as long as the United States remains the preferred destination of Japanese FDI.

Also, European firms themselves will be incteasing their investment within Europe in anticipation of the growth of their regional markets, which will also reduce their interest in FDI in developing countries. In addition, as the reduction of intra-regional barriers makes imports from developing countries less competitive with goods produced in Europe, there will be less incentive for expert-oriented FDI projects in developing countries that serve European markets. Over the longer term, however, the income-increasing effects of further integration in Europe will increase the demand for imports, including imports from FDI projects in developing countries.

Nevertheless, the net effect of all these factors on FDI in developing countries is unlikely to be dramatic. FDI, particularly in the primary sector is unlikely to be affected much at all, at least in the short term, and will probably be positively influenced in the long term. In the secondary sector, because the production processes in many manufacturing industries, such as motor vehicles, are already highly integrated internationally and include component and assembly operations in developing countries, increased manufacturing FDI in Europe is unlikely to replace FDI projects in developing countries. Finally, FDI in services in developing countries is more affected by local host-country market conditions and FDI policies than by conditions in Europe. In sum, then, the consequences of the EC 1992 program may reduce FDI flows from developed to developing countries somewhat below what they would have been over the next several years, but it is unlikely to have a significant effect.
47 The United States will continue to attract large amounts of FDI, particularly from Japan, as the U.S. trade deficit persists. Thus, macroeconomic conditions and policies in the. developed countries will continue to be major influences on FDI flows to developing countries, just as the macroeconomic conditions and policies of the developing host countries themselves will continue to be important influences.

# onclusio

Any consideration of the future of FDI in developing countries should not be limited to an analysis of aggregate quantities of flows of resources to developing countries because the effects of FDI can often be understood best at the levjl of individual projects. FDI is qualitatively different because it consists of a bundle of services with diverse effects on the local economy and projects are integrated into large, often global, corporate networks.

FDI projects thus make distinctive contributions to the development process. They bring in new production and other technologies, new managerial skills, new marketing and finance opportunities, new approaches to a variety of managerial issues, and new relationships with the world economy. Even in cases where the FDI project is in the form of an acquisition of existing companies, the new foreign owner often makes changes in operations and strategic orientation.

Such changes may not only contribute to the economic development process, but also have controversial political and cultural consequences, as well as economic costs. For example, highly protective incentives to attract FDI may result in distorted resource allocation. In any case, questions about the distribution of the costs and benefits of FDI, and its noneconomic effects, will always be raised. Although the recent changes toward more positive attitudes about FDI in many developing countries are surely indicative of a much more receptive climate of opinion, some degree of ambivalence and a consequent desire to control foreign-owned business will continue. The future of FDI in developing countries will therefore be shaped to a great extent by the government-business interactions involved in the entry negotiations and the operations of individual projects. There will consequently continue to be significant variations across industries and host countries in the patterns and trends of FDI in developing countries.

Such variations do not alter the central fact that a new FDI era has emerged--an era marked by a greater recognition of the benefits of FDI in the development process. In this era, the focus of attention has shifted to the specific, tangible ways that host governments (as well as home governments and international institutions) can change their policies and devise new mechanisms to facilitate the flow of FDI to developing countries. 'It is an era of pragmatic cooperation and policy innovation.

To this end, there is an important scope for the World Bank group, especially with the establishment of MIGA, to assist host governments in their efforts to translate more positive attitudes about FDI into tangible policy reforms, will be increasingly important.