metadata: authors: 0: author: Morisset,Jacques
docna: 0: docna: Does a country need a promotion agency to
            attract foreign direct investment : a small analytical model
            applied to 58 countries
docty: Policy Research Working Paper
subtopic: Investment and Investment Climate,Business Environment,International Trade and Trade Rules
teratopic: International Economics and Trade
abstracts: cdata!: Establishing an investment promotion
            agency has become a central part of most countries'
            development strategies. Today there are more than 150
            investment promotion agencies worldwide. Yet very little is
            known about what these agencies have been really doing,
            notably in emerging countries, and whether they have been
            effective in influencing investors' decisions. Using
            data from a new survey on 58 countries, Morisset shows that
            greater investment promotion is associated with higher
            cross-country foreign direct investment (FDI) flows, on top
            of the influence of the country's investment climate
            and market size. But this result has to be qualified on
            several counts. First, the effectiveness of the agency
            depends on the country's environment in which it
            operates. An agency in a poor investment climate is less
            effective at attracting investment. Second, the scope of
            activities that an agency undertakes influences its
            performance. Morisset's empirical analysis indicates
            that agencies devoting more resources on policy advocacy are
            more effective because such activity is not only beneficial
            to foreign investors but also to domestic investors. In
            contrast, investment generation or targeting strategies
            appear expensive and risky, especially in countries with
            poor investment climates. Finally, certain internal
            characteristics of the agencies are associated with greater
            effectiveness. The agencies that have established reporting
            mechanisms to the country's highest policymakers (the
            president or prime minister) or to the private sector have
            been systematically more efficient at attracting foreign
            direct investment. Such institutional links are crucial
            because they contribute to strengthen the government's
            commitment as well as reinforce the agency's
            credibility and visibility in the business community.
repnme: repnme: Does a country need a promotion agency to
            attract foreign direct investment : a small analytical model
            applied to 58 countries
display_title: Does a country need a promotion
            agency to attract foreign direct investment : a small
            analytical model applied to 58 countries
listing_relative_url: /research/2003/04/2329622/country-need-promotion-agency-attract-foreign-direct-investment-small-analytical-model-applied-58-countries
topicv3: Investment Climate m1326293 405,Trade m1326924 698,Investment Promotion m1504556 2552,Investor Servicing and Aftercare m1504560 2637,Business Environment m1586411 2530
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
origu: FIAS
no_of_pages: 28
author_keys: 0: author_key: 99192
model_extractions: POLICY RESEARCH WORKING PAPER 3028

# Abstract

Establishing an investment promotion agency has become a central part of most countries' development strategies. Today there are more than l50 investment promotion agencies worldwide. Yet very little is known about what these agencies have been really doing, notably in emerging countries, and whether they have been effective **in** influencing investors' decisions.

Using data from a new survey on 58 countries, Morisset shows that greater investment promotion is associated with higher cross-country foreign direct investment (FDI) flows, on top of the influence of the country's investment climate and market size.

But this result has to be qualified on several couIIts. First, the effectiveness of the agency depends on the country's environment **in** which **it** operates. An agency in a poor investment climate **is** less effective at attracting investment. Second, the scope of activities that an agency undertakes influences its performance. Morisset's empirical analysis indicates that agencies devoting more resources on policy advocacy are more effective because such activity is not only beneficial to foreign investors but also to domestic investors. In contrast, investment generation or targeting strategies appear expensive and risky, especially in countries with poor investment climates.

Finally, certain internal characteristics of the agencies are associated with greater effectiveness. The agencies that have established reporting mechanisms to the country's highest policymakers (the president or prime minister) or to the private sector have been systematically more efficient at attracting foreign direct investment. Such institutional links are crucial because they contribute to strengthen the government's commitment as well as reinforce the agency's **credibility** and **visibility** in the business community.

This paper-a product of the Foreign Investment Advisory Service-is part of a larger effort **in** the Bank to understand foreign direct investment flows. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Monte Feghali, room 19-110, telephone 202-473-6177, fax 202-522-3262, email address mfeghahi@ifc.org. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at jmorisset@worldbank.org. April 2003. (22 pages)

> _The Policy Research Working Paper Senes dtsseminates the findings of work_ **_in_** _progress to encourage the exchange of ideas about development issues. An objective of the series_ **_is_** _to get the finditgs out quickly, even if the presentations are less than fully polished. The papers carry the names of the auithors and shotld be cited accordingly. The_ **_findings,_** _interpretations, and concluszons expressed in this paper are entirely those of the authors They do niot necessanly represent the_ **_view_** _of the World Bank, its Executive Directors, or the countries they represent._

Produced by the Research Advisory Staff
DOES A COUNTRY NEED A PROMOTION AGENCY TO ATTRACT FOREIGN DIRECT INVESTMENT? A small **analytical model applied** to **58 countries** by Jacques Morisset' l Lead Economist, Foreign Investment Advisory Service (FIAS). I am especially grateful to<sup>Professor L.</sup> Wells for his support at various stages of this research project. I also benefited from comments<sup>on another</sup> version of this paper from J. Battat, F. Sader, N. Roger, J. Bergsman, D. Weigel,<sup>andS. Djankov.K.</sup> Johnson, A. Minoux, N.Smith and A. Alvarez contributed to this research.
**1. Introduction**

Establishing an investment<sup>promotionagency hasbecome acentralpart of most</sup> countries' development<sup>strategies.Today,there are worldwidemore than160national</sup> investment promotion agencies<sup>(IPAs)and over 250sub-national ones(UNCTAD,2001).</sup> This trend is relatively<sup>newsinceonlya handfulof theseagenciesexisted20 yearsago.</sup> Yet, the reality is that very<sup>little isknown aboutwhat theseagencies are actuallydoing in</sup> most countries, especially<sup>in the developing world.</sup> The objective of this paper<sup>is toassess to what extent doesinvestmentpromotionhelp</sup> explain cross-country variations<sup>in foreigndirectinvestment(FDI) flows.We proposea</sup> model<sup>in whichthe promotionagency'sbehavior is assumed to reflect</sup> simple analytical the interest of the government<sup>(or a supervisoryboard) under the constraint of limited</sup> budgetary resources. It<sup>followsa certain traditionin public finance,see Heller,1975.</sup> Our model remains simple,<sup>as</sup><sup>**it**is principallyuse to derive an equationthat can be easily</sup> estimated for our sample<sup>of countries. It shouldalso be seenasa complementto the</sup> seminal work of Wells and<sup>Wint, 2001,whohaveprovidedthe theoreticalunderpinnings</sup> of adopting investment promotion<sup>policies toattractFDI.2</sup> Due in part to a lack of reliable<sup>data,no broad empiricalstudy of investment promotion</sup> agencies and their effectiveness<sup>in attractingFDI hasbeen doneto date3.This empirical</sup> gap means that the debate<sup>onthe effectivenessof IPAsis still very open.Weuse data</sup>

**2** Wells and Wint (2001)<sup>defineinvestment promotionas</sup><sup>_"activities that disseminate information about, or_</sup> _attempt to create an image of_<sup>_the investment site and provide investment services for the prospective_</sup> _investors"._ This definition<sup>encapsulatesthetwo mostimportant analytical justificationsfor IPAs.Thefirst</sup> consists of its role **in** communicating<sup>and disseminatinginformation.Since thislatter can be consideredas</sup> a public good, **it is** possible<sup>that the privatesector behaviorwillnot leadtothe optimalsocialwelfare. Asa</sup> matter of fact, local firms<sup>may voluntarilyrestrict information flowstoprevent the entryof new potential</sup> competitors. The second<sup>justificationis that theIPA canplay a roleof coordinatingmost activitiesaimed</sup> at improving the business<sup>environmentin the host country.This role can rangefrom providingassistance</sup> to potential and existing investors<sup>**in**their daily problems to lobbying forkey policyand legal reforms.</sup>

3 The only empirical examination<sup>of theimpactof FDI promotionon FDI flowswasconductedby Wells</sup> and Wint, 2001, based on data<sup>gatheredin1988.Thisstudyhad seriousshortcomingsinterms of the</sup> concept used to measure the<sup>promotion</sup> 3
from a new survey that was conducted in 58 investment promotion agencies between February and May 2002.4 At the outset, it is worth underscoring that our research should be viewed as a first attempt to fill the existing empirical gap and has obvious limitations. The most important is that we have been only able to examine empirically the relationship between promotion and foreign direct investment at one point in time, specifically the year 2001. Unfortunately, data are simply not available for additional years. We believe that it nonetheless provides some answers to four sets of questions that should help IPA managers and policy makers to develop a better understanding of the conditions -both external and internal to the agency-- that influence the effectiveness of promotion:

- How does the amount of spending on investment promotion affect its effectiveness? Does an agency need to exceed a minimum level to have any effect on international investors?

- To what extent does the business environment or the country's characteristics affect the effectiveness of investment promotion? Does the quality of the general business environment matter?

- Does the effectiveness of investment promotion vary according to the functions or activities on which it focuses? Should an IPA devote more resources toward policy advocacy or image building?

- Is the effectiveness of investment promotion influenced by different agencies' characteristics such as their structure, mandate, sources of funding, and institutional relationships?

The paper proceeds as follows. In Section II we begin by presenting a small analytical model through which we explain the behavior of an investment promotion agency. Section Em[ discusses the selection of variables as well as the main sources of data used for the application of the above model. Section IV presents the main empirical results

> 4The questionnaire was sent via email or fax to 114 agencies, both from developing and industrial countries. We received responses from 75 agencies, yielding a response rate of 66%. The rate was higher in Latin America and in Eastern and Central Europe where it reached 86% and 71%, respectively. A description of the **main** responses can be found in the FIAS website (www.fias.net).

4
and provides a few interpretations. Finally,<sup>Section V concludes and offers a few</sup> directions for future research.

# **II.** A Small Analytical Model

To our knowledge, there has been no attempt<sup>to captureanalytically the behavior of</sup> investment promotion agencies. Here we adopt<sup>a simpleapproach basedon the</sup> assumption that governments will strive to<sup>maximizethe levelof FDI inflowsthrough its</sup> promotion effort and at the same time, minimize<sup>resources allocatedto thiseffort.The</sup> assumption that the agency attempts to maximize<sup>the levelof FDI is basedon the</sup> observation that for most countries the effectiveness<sup>of promotionis measuredby its</sup> capacity to attract (foreign) private investment.<sup>It is truethat somesophisticated IPAstry</sup> to do more: some aim at increasing the<sup>quantityas wellas the qualityof FDI, where</sup> quality might be measured by investments<sup>impact- in terms of job creation, exportsor</sup> technology transfers. Nonetheless, all<sup>developingcountries are firstand foremost</sup> interested in attracting more PDI; suggesting<sup>that the IPA performancecan be evaluated</sup> on the basis of this shared goal.

At the same time than maximizing FDI inflows,<sup>the governmentwill attemptto minimize</sup> the use of public resources required to finance<sup>the promotioneffort.Again,this</sup> assumption might be excessive because it could<sup>be argued that promotionagencieshave</sup> access to other sources of funding. Still,<sup>public funds accountfor the about 70%of EPA</sup> budgets worldwide -this percentage exceeds<sup>even80%for developingcountries.</sup> Alternative sources of funding, such as<sup>private or externalsources, have been inconsistent</sup> or weak complements because of the public<sup>nature of investmentpromotion.</sup> The government, or a set of policymakers,<sup>maximizestheir utility,taking into account</sup> uses of public resources required to finance the<sup>promotioneffort (P) and the objective to</sup> attract FDI. In any period, we assume the utility<sup>function of the IPA definesas:</sup> _5_
_U = ao + a, (FDI - FDI*) - 22 (FDI-FDI*)2 _a3(P_P*)+a4 (p_p)2_ (1) 2 2 with a, _>-_ O

> Following Heller,1975, the selection of this functional form ensures diminishing marginal

> utility for any increase in FDI and increasing marginal (dis)utility for P, as these variables rise above a level determined by their target levels (defined with the symbol *). It reflects a compromise between the need for an estimable functional form with desirable utility function properties.S

The target FDI*, or the desired level of FDI, is set in the context of the literature on FDI that assumes that long-term FDI flows are defined by a series of structural variables such as the level of economic development and the quality of the investment climate in each country.

_FDI =_ **_yC_** _+_ **_Y 2Y_** where IC is an indicator of the quality of the investment climate and Y the level of economic development or the market size. These two variables have been retained following the recent literature on the determinants of FDI. The importance of these two factors is linked with the two main motivations for FDI: investments are especially sensitive to the investment climate, since multinational can generally choose between locations; investments aimed at the local market are most easily attracted by large **6** markets. In our attempt to select these extemal variables, we also considered others factors, in particular infrastructure and education variables, as well as regional dummies, but those added only limited and inconsistent explanatory power.

> _5_ See Heller, 1975, or Mosley et al., 1987, for a similar utility function.

> **6** These two motivations are sometimes referred as vertical and horizontal FDI. For a good summary on these views, see S. L. Brainard, 1997.

_6_
We assume that the level of promotion has no<sup>effecton the desiredlevelof FDI in long-</sup> run following the arguments developed by Wells<sup>and Wint,2001, that justify the use of</sup> investment promotion principally on a temporary<sup>basis.Promotionagenciesare viewed</sup> as vehicles for addressing coordination and information<sup>issues that tend todisappear over</sup> time. Since promotion does not influence FDI<sup>flows in thelong run,we canwritethat</sup> the desired level of public resources devoted<sup>to promotionis, equalto 0.</sup> P* = 0 Next, we capture the eventual temporary influence<sup>of investment promotionon FDI flows</sup> by: _FDI = AP_ with A Ž0 Maximizing equation (1) with respect to FDI and P<sup>and subjectto constraint(4)yield tc</sup> the following equation: _FDI = /o + A3P +8 21C +/33 Y_ From equation (5) we define PI as a measure<sup>of IPA effectiveness.Since our modelwill</sup> be estimated in logarithmic form, the value<sup>of</sup> PI<sup>describesthe elasticity of the investment</sup> promotion effort and FDI inflows. The main<sup>featureof equation(5)isthat theIPA</sup> effectiveness is measured by taking into account<sup>the influenceof externalvariables and</sup> IPA characteristics. Such influence has to be<sup>consideredbecausean increase in FDI</sup> flows can occur independently of a greater promotion<sup>effort,for example throughan</sup> improvement in the macro-economic stability,<sup>and a consequentpositive relationship</sup> observed between the promotion effort and FDI<sup>may only be-spurious.</sup> 7
The basic model remains can be extended in three directions. First, the coefficient fi, is likely to vary depending on the country's policy environment even though it is not clear a priori in which direction. For example, one might suspect that investment promotion is more effective in a good than in a poor policy environment because it is easier to convince potential investors to come to an attractive country. However, in such a context, it could also be argued that the agency is redundant. Most investors are well aware of opportunities in their field or industries, and do not really need to contact (or to be contacted by) an investment promotion agency.

To account for the influence of the environment on IPA effectiveness, equation _(5)_ can be modified by associating multiplicative dummy variables to the promotion effort. These dummies will be defined to test whether threshold values in the external variables, say the quality of the investment climate influences the effectiveness of the promotion agencies. This approach lies on the belief that above or below specific values the role and performance of the promotion agency differ. Alternatively, we can explore the possibility of a linear relationship between the effectiveness of promotion and the country's environment. Following Burnside and Dollar, 2000, this can be done by adding an interaction termn between the promotion effort and the investment climate into equation (5): _FDI = 3o +/AP+/2EV+/3 (PxIC)_ (6) where IC is defined as the log of the investment climate indicator used. Taking the derivative of the FDI inflows with respect to the promotion effort, we can identify the relationship between the IPA effectiveness and the quality of the investment _aFDI_ climate, = _i_ + _J,63IC._ The IPA effectiveness is defined as a linear function of the quality of the investment as long as the coefficient _,83_ is significantly different from 0.

The second extension is to assess whether IPA effectiveness is influenced by which functions does the agency carry on. To capture these functions, we simply rewrite our 8
basic equation _(5)_ by<sup>separatingthe promotioneffort (P)intheseveral categoriesdefined</sup> by Wells and Wint,<sup>2001; thatare image-building,investor servicing,investment</sup> generation, and policy<sup>advocacy.Theseactivitieshave been extensivelydetailed by these</sup> two authors and will<sup>not be explainedin thispaper (see AnnexA for a briefsummary).</sup> Here it suffices to indicate<sup>that theyare generallywell known bymanagersof investment</sup> promotion agencies<sup>andexpertsin thatfield.</sup> A third and final extension<sup>is to incorporatea number of internalcharacteristicsof the</sup> promotion agencies<sup>asexplanatoryvariables into equation(5).In doingso, we follow</sup> again Wells and Wint,<sup>2001.In particular,theseauthors haveargued thatsuch</sup> effectiveness rnight be<sup>strengthened when the agency benefits from the involvement of</sup> the private sector and<sup>a focusmandate on investment promotion.</sup>

# **III. Definition of Variables**<sup>**and Sources of Data**</sup>

This section discusses,<sup>first, theselection of variablesused for the applicationof the</sup> model developed above.<sup>Then, we briefly describe someof themethodologicalchoices</sup> that we had to face.

We used as a first indicator<sup>total gross FDI inflowsas definedby UNCTAD,whichoffers</sup> a more complete country's<sup>coverage thanthe IMF or the World Bank's database. This</sup> indicator presents the<sup>double advantageto be relativelyhomogenousacrosscountriesand</sup> relatively well used<sup>in theeconomic literature,thereforefacilitatingcomparisons.It may</sup> be however biased for<sup>our purposeof measuringthe IPA effectivenesssince many</sup> agencies have reported<sup>that they do not have the main responsibilityfor privatizationand</sup> for the mining sector<sup>--twoimportant channels of FDI worldwide.For thisreason, using</sup> the UNCTAD data,<sup>we adjustedgrossFDI flows by the amountof Merger&</sup> Acquisitions (M&A)<sup>in each country.Theidea is to capturemore accuratelythe FDI</sup> flows that are under<sup>the direct control of most IPAs.</sup> 9
> The promotion effort (P) is measured by the annual budget of each agency converted into

> US dollars. This conversion assumes that each dollar spent by the agencies has the same

> value across countries, which might introduce inconsistencies for cross-country

> comparisons. While the costs of certain promotional activities are independent of the

> IPA location (e.g., the cost of an advertisement in an international newspaper would in principle be the same for Ethiopia and Germany), some expenses vary greatly across

> countries. For these reasons, we also measure the promotion effort by the number of

> professional staff dedicated to investment promotion in each agency. This proxy does not

> vary with the exchange rate and accounts for different purchasing value across countries. However, it makes the strong assumption that labor (rather than money) determines the

> level of promotion effort in each country. Both variables -the IPA budgets and staff-

> have been extracted from the survey conducted by the Foreign Investment Advisory

> Service of the World Bank in early 2002.

> As explained earlier, the promotion effort has been separated into four categories so that

> we can capture better what IPA do. We follow Wells and Wint, 2001, and distinguish the following activities: investment generation (IG), policy advocacy (PA), investor servicing (IS), and image-building (IB). The budgetary resources allocated to each of these functions have also been identified using the FIAS survey.

> The internal characteristics of the agency have been captured through the FIAS survey, including a) age of the agency, b) legal status (founded by law or decree), c) institutional affiliation and linkages with government (public, semi-public, autonomous, or private body), d) linkages with the private sector (financial contribution, frequency of meetings and inputs, degree of private sector representation on board), e) reporting arrangements

> (board, government body, prime minister or president), f) overseas offices, g) number of mandates on top of foreign investment promotion (e.g., export promotion, privatization programs,) and f) staff's characteristics and salary policy.

> We tested several indicators of the quality of the investment climate such as the ones developed by the World Economic Forum, Harvard, the Heritage Foundation,

10
Intemational Country Risk, etc. After numerous<sup>tests, we selected theHeritage Indexas</sup> it had added the highest explanatory power to our model.<sup>7Similarly, we used threeas</sup> alternative indicators for the local market size: GDP, population,<sup>and incomeper capita.</sup> All these variables appear highly correlated for<sup>our sample of countries,and the levelof</sup> income generated the most robust results per capita,<sup>hence we retained thisvariable.</sup> We explore the relationship between the investment<sup>promotioneffort and FDI inflowsin</sup> 58 countries during 2001.8 Our sample is diversified<sup>in termsof regions,levelof income</sup> per capita, as well as the magnitude of investment<sup>promotionefforts.To keepsome</sup> homogeneity, we include only countries that have<sup>reportednationalinvestment</sup> promotion agencies. We exclude countries, such<sup>as the US,China,Brazil, andIndia,that</sup> have only regional agencies since it was difficult<sup>to assess theircontributionto FDI flows</sup> at the national level. This omission may be important<sup>because thesecountries accountfor</sup> a substantial share of FDI worldwide.

While the data obtained from the FIAS survey are<sup>unique, they areonly availablefor the</sup> year 2001. For this reason, our approach can<sup>only be cross-sectional.By doing this,we</sup> do not necessarily assume that promotion has an immediate<sup>effect on overallFDI flows</sup> because we use a cross-country rather than time-series<sup>analysis.Our results would be</sup> significantly biased only if we had depicted large<sup>variationsin the promotioneffort over</sup> the last few years. Fortunately, it appears that variations<sup>in the promotioneffort across</sup> 7 Indeed, as recently confirmed by Batra and Moody,<sup>2002,variationsin cross-countryFDIflowsare well</sup> explained by these factors over the past decade. The Heritage<sup>FoundationIndexcaptures50 independent</sup> variables divided into 10 broad factors of economic freedom<sup>related to internal andexternal</sup> macroeconomic conditions, economic openness,<sup>and politicaland institutionalhealth.The higher thescore</sup> on a given factor, the greater the level of government interference<sup>in theeconomyand theless economic</sup> freedom a country enjoys. The index assigns scores<sup>inversely to the state of the investmentclimate;hence</sup> we expect a negative sign on the coefficient of the<sup>estimation.</sup> 8 'he list of countries is the following: Armenia, Bangladesh,<sup>Belgium,Benin, Bolivia,Bosnia And</sup> Herzegovina, Bulgaria, Cape Verde, Chile, Colombia,<sup>Costa Rica,CoteD'Ivoire,Czech Republic,</sup> Denmark, Dominican Republic, Ecuador, El Salvador,<sup>Estonia, Ethiopia, Finland,Georgia,Greece,</sup> Guyana, Honduras, Hong Kong,, Indonesia, Ireland,<sup>Israel, Jamaica,Jordan, Kenya,Korea, Latvia,</sup> Lesotho, Malawi, Maldives, Mali, Mauritius, Morocco,<sup>Mozambique,Nepal, Pakistan,Panama, Paraguay,</sup> Peru, Portugal, Senegal, Slovakia, Slovenia, South<sup>Africa,Sri Lanka, SaintLucia,Thailand,Trinidad and</sup> Tobago, Tunisia, Uganda, Vanuatu, Venezuela.
countries reported for the year 2001 are not significantly different than those that existed in the late 1990s.<sup>9</sup> We use the Ordinary Least Squares (OLS) technique to estimate our basic FDI equation. In doing so, we assume that the level of promotion effort is weakly exogenous in the sense that the promotion effort is not contemporaneously affected by FDI flows. Although we cannot, in the absence of time-series analysis, prove that causality runs from promotion to investment, it seems unlikely that increases in foreign investment will typically cause an increase in the promotion effort. Recent experience suggests that IPA budgets are determlined and approved within a business plan that usually covers a 3-5 year period. They are rarely revised as a result of FDI flows, at least not in the short term. Moreover, since the main source of IPA funding is the government, some degree of inertia is expected to be associated with public finance decisions.<sup>10</sup>

# lWv. Empiricall ResuRts

Our main empirical results are summarized in the Table 1. Overall, the results appear satisfactory, as the explanatory power of the regressions is relatively high, in spite of the limited number of explanatory variables.

By assuming that causality runs from promotion effort to FDI flows, we find that investment promotion is positively associated with cross-country variations in FDI flows -the elasticity coefficient is equal to 0.25. More importantly, this finding holds when we account for the influence of the investment climate, as measured by the Heritage Index, and the level of development in each country. It also continues to be robust using

> **9 For** fuller details on this point, see Morisset and Johnson, 2003.

> **10** Of course, abrupt changes in **IPA** budget are always possible due to budgetary crises in government or the termination of external assistance. However, these events occurred in a very few countries of our sample, hence we believe that they will not significantly affect our empirical results that capture trends across a sample of 58 countries.

12
alternative definitions of FDI<sup>inflows.Still, our simple and restricted correlationbetween</sup> the IPA budget and FDI must<sup>be interpretedwith caution.The positive and significant</sup> correlation does not necessarily imply<sup>that promotionalwayspositivelyaffectsFDI,but it</sup> makes it more difficult to argue<sup>that promotionis infact bad for attracting FDI. The</sup> positive correlation, in other words,<sup>restrictsthe range of possibilities.</sup>

**Table 1: Estimated Elasticity Coefficients**<sup>**a/,b/,c/**</sup> (t-statistics in Parenthesis)

||FD|I|FDI(ADJ<br>FORM<br>|USTED<br>&A)|
|---|---|---|---|---|
|IPABudget|.25||.31<br>||
||(2.41)||(3.33)||
|IPAStaff||.26<br>||.20<br>|
|||(1.56)||(1.14)|
|investmentclimate-Heritage|-1.62|-1.64|-1.78<br>|-1.90<br>|
||(4.09)|(-3.80)|(4.15)|(4.12)|
|GDPpercapita|.57|.73|.42<br>|.49<br>|
||(2.48)|(3.10)|(1.67)|(2.11)|
|Observations<br>|58<br>|49<br>|51<br>|43<br>|
|AdjR<sup>2</sup>|.682|.683|.696|.681|

# Notes:

a/ All variables are in logs except<sup>for the Heritage Index.for whichan improvementcaptured by</sup> a decline in the indicator.

b/ We omitted to report the constant<sup>term.</sup> c/ Numerous other external variables<sup>were tested inthe regressionsincluding GDP,regional</sup> dummies, other investment climate indicators.<sup>In general,the results wererobust independently</sup> of the inclusion or exclusion of these variables.

This positive association<sup>is found whenthe promotioneffort is measuredby theIPA</sup> budget. When effort is measured<sup>by the levelof humanresources,therelationshipisalso</sup> positive, but not statistically significant.<sup>It is possible that theclose relationshipof FDI</sup> to expenditures means that promotion<sup>activitiesrequire lesslabor thanmoney.Anecdotal</sup> evidence collected at the country<sup>levelreveals thatfixed labor costsusuallyaccountfor</sup> less than one-third of an agency<sup>total budget--the bulk of expensesis associatedwith</sup> buildings, promotion materials,<sup>advertisement,andpromotionaltrips.</sup> 13
One concern is that the IPA effectiveness is affected by the size of their budgets, which vary considerably across countries.<sup>1</sup> ' Using a kernel or neighborhood function'<sup>2</sup> we find that up to a minimum budget of about US$64,000 IPAs seem to have no (or even negative) impact on FDI. Between a budget of US$64,000 and US$2 million -IPAs are effective, and the elasticity is about 0.5. Between US$2 and US$11 million, the estimated elasticity reaches its maximum value. On average, we find that a 10 % increase in the IPA budget is associated with a 7.5% increase in FDI flows, which is three times higher than the elasticity estimated for the entire sample. Finally, above a budget of about US$11 rmillion, promotion expenditures are ineffective.

> Although these results should be interpreted with caution, they suggest that small agencies are not really effective at attracting FDI. Presumably, the existence of a threshold reflects the significant fixed costs associated with numerous activities, such as advertising and image building.<sup>13</sup> Still, agencies that are too big have their own

> problems. There is a maximum level of resources beyond which there are decreasing economies of scale -even though this limit appears out of reach of many agencies. The

> existence of decreasing marginal returns can also be explained in the light of the analytical arguments used to justify the creation of IPAs. Beyond a limit, it is unlikely that the agency can contribute more to resolving the information and coordination issues that had justified its creation.

It is worth underscoring that we have not been able to depict any significant patterns associated with the size of IPAs budgets. For example, we did not find that IPA budgets were significantly correlated to country's size or levels of development -at for our sample of countries. Granted, IPAs located **in** industrial countries have generally higher budgets than those located **in** developing countries, but this positive correlation does not hold for other categories such as low income and middle income countries.

12 This method is adaptive and dynamic in the sense that the slope parameter changes along the regression curve depending on the location of the varnables in the sample. More specifically, we minimize the weighted sum-of-squared errors between the actual and the fitted by allowing the program to compute a regression at every point in our data set. A kernel fit is superior to the regression analysis because the latter assumes constancy of the slope parameters.

13 This is easy to understand: an advertising campaign in an international newspaper can reach several thousands of US$ dollars; promotional trips and participation to fairs can be equally expensive; as are the needs of potential investors when they visit the country.

14
Our empirical analysis clearly confirms<sup>that the qualityof theinvestment climate andthe</sup> level of development have a significant<sup>effecton IPAperformance.14The better the</sup> investment climate, the greater IPA<sup>effectiveness.Similarly,the higherthe levelof</sup> development; the more effective an<sup>IPAis.Theselinear relationshipsbetweenthe IPA</sup> effectiveness and these external variables<sup>arecaptured in thetwo followingequations(all</sup> variables are expressed in logs): More concretely, by applying these relationships<sup>to our sample of countries, they indicate</sup> that the IPA effectiveness ranges from<sup>0.16 for the agencylocatedinthe country with the</sup> worst investment climate to above<sup>0.35for thecountry with the best investmentclimate.</sup> Similar large differences in the impact of<sup>the promotioneffortarealso depictedin</sup> function of the country's income per<sup>capita..</sup> We now turn to the question whether<sup>promotion effectivenessisinfluencednotonly by</sup> the amount of resources spent by the agency<sup>but also by howtheseresourcesare</sup> allocated across its functions or activities.<sup>We estimatedequation(5),except that we</sup> broke IPA spending into the four components<sup>identifiedearlier to detecttheir influence</sup> on FDI inflows. Each function was<sup>estimatedseparatelyto avoidmulti-colinearity</sup> problems between these variables. The<sup>estimatedelasticitycoefficientsare presentedin</sup> Table 2.

The estimated results reveal that policy advocacy<sup>appearsto havethestrongestimpacton</sup> F'DI inflows, followed by image-building,<sup>investor servicing,and investmentgeneration.</sup> However, there does not appear to be a<sup>significantdifferencebetweenimage-building</sup> and investment servicing, both of which<sup>appear equallyeffectiveand not far behind</sup>

> 4 We were unable to identify threshold values<sup>using multiplicativedummues.</sup>

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policy advocacy. 1516 Our finding that policy advocacy seems to be the most effective IPA function is consistent with our previous result that IPA effectiveness is positively correlated with the quality of the investment climate. Most IPAs are in a strategic position to carry out policy advocacy activities because of their interface between the private and the public sector. By contrast, the weak elasticity coefficient associated with the investment generation function can be explained by the high cost and high degree of expertise required to effectively carry out targeted programs. An agency needs specialists, by sectors or enterprises, and usually time and attention to convince a particular n investor to locate in its country. Most practitioners would agree that for each US$1 spent, investment generation has the lowest return, and especially in our sample that includes a majority of countries with relatively poor investment climates.

Table 2:

|ElasticityCoeffcie|ntbyIPAFunctions|
|---|---|
|FUNCTION/|ELASTICITY COEFFICIENTS|
|PolicyAdvocacy|.30<br>(2.14)|
|ImageBuilding|.25<br>(2.32)|
|InvestorServicing/Facilitation|.24<br>(2.17)|
|Investment Generation|.18*<br>(1.79)|

> *All coefficients are statistically significant at 5%, except the one associated with investment generation, which is at the 10% level.

> _15_ The three coefficients associated to these variables are not significantly different from each other at the 5% level, but only at the 10%.

> 16 These estimated results represent an average for all IPAs, they do not account for the charactenstics of each country in which the IPA is located. As we did earlier for the overall IPA budget, we explore whether the effects associated with each function vary depending on the country's environment but, in that case, we were unable to find any statistical variations in our sampleWe used the same approach than for the overall

> EPA budget, but apply it to each EPA function. Unfortunately, these series of tests were non-conclusive in depicting any significant cross-country differences in the estimated impact of each EPA function.

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The conceptual framework developed by Wells and Wint, 1990 and revised in 2001, suggests that an IPA's effectiveness is influenced by its institutional structure and reporting mechanisms. Although we tested several internal characteristics using both dummy variables and interactive **tenns** associated with the IPA budget variable, only three of them seem to have significant effects on the effectiveness of IPAs across countries (Table 3)17. First, FDI flows are significantly lower in countries where the IPA is part of a ministry in contrast to be an autonomous body or a joint private-public institution. Second, the effectiveness of IPAs is enhanced when the agency reports to a supervisory board that includes representatives of the private sector --- the higher the number of private members, the greater IPA effectiveness<sup>18</sup> . Finally, IPA effectiveness<sup>is</sup> enhanced when it reports directly to a country's president or a prime minister.

Table 5: The influence of IPA characteristics on FDI Inflows (T-statistics in parenthesis)

|DependantVariable/ExplanatoryVariable|FDI|FDI|FDI|
|---|---|---|---|
|Publicagency*dummy|-.79<br>(-2.43)|||
|NumberofprivaterepresentativesintheBoard *Budgetc/||.052<br>(2.72)||
|PrimeMinister/PresidentDummy|||.53<br>(1.80)|
|IPABudget|.21<br>(1.95)|.22<br>(2.01)|.25<br>(2.29)|
|Observations<br>|56|36|55|
|AdjR<sup>2</sup>|0.71|0.72|0.68|

Notes: a/We omit to report the results associated with the constant term, GNI per capita, the Heritage Index that wei e also included in the above regressions.

b/All variables are in logs, except for Heritage Index and the dummy variables.

c/ The number of representatives starts from 1 to the maximum registered in our survey.

17 The methodology was twofold. First, we used dummy variables and, second, an interactive term multiplied to the IPA budget. The first approach captures the possible effect of the EPA characteristics on the FDI flows, independently of the promotion effort. The second approach assumes a linear relationship between the EPA budget and the EPA characteristics. These two approaches have been detailed **in** the precedent technical appendix.

**18** An agency with **I** private representative would report an elasticity coefficient equals to 0.22, while an agency with 8 private sector representatives in its Board will see its effectiveness increase to about 0.32.

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These findings confirm that the most effective IPAs benefit from visibility and from participation by the private sector through their boards or through institutional relations. These characteristics reinforce the leverage of the agency and its role. They also indicate that including the private sector contributes to broaden the platform and help to achieve a consensus in the agency's effort to market the country abroad. Yet, they should not be used to overestimate the role of the investment agency. The reporting mechanism to the president or the prime minister may reflect the overall commitment of the government toward reforms. Within that context, the positive correlations reported above, while indicative, would capture this global trend in the government's effort rather than the agency's own performance.

Finally, it is worth reporting that some IPA characteristics do not seem to influence the agency performance. The agency's mandate, staff qualification, and the number of overseas agencies have no significant effect on FDI flows. It is possible that these characteristics do not matter. Another possibility is that our survey has too little variations in these factors to identify their eventual impact on the effectiveness of IPAs.

# 'V. Concllsion and Policy Recomximendations

The story that emerges from our investigation is that the IPAs are effective in influencing decision to invest. Although our empirical exercise suffers from obvious limitations, their role seems significant, on top of the influence of key factors such as the quality of the investment climate and the country's market size.

The finding that promotion is positively associated with FDI inflows across countries has to be qualified because it is closely link to the environment in which the agency operates. Investment promotion is more effective in a country with a good investment climate and a relative high level of development. In fact, our results suggest that promotion can be even counterproductive in a country that offers a poor investment climate. It seems more difficult to convince an investor to come back if he was disillusioned during his first visit 18
to a country. The disappointed<sup>investor is also likelyto be vocalabout his</sup> disenchantment and, so, discourage<sup>other potentialinvestors.</sup> The functions carried on by<sup>the promotionagencycaninfluenceitseffectiveness.Our</sup> empirical results reveal that<sup>policyadvocacy is themost effectivefunctionfor attractinga</sup> dollar of investment, followed<sup>by image-building,and investorservicing.Investment</sup> generation appears to be the<sup>least efficient or cost-effective, partly becauseit is expensive</sup> and partly because it is often<sup>not adaptedto the reality of our sample of countries that</sup> have relative poor investment<sup>climates.While the optimallevelof budgetthat should be</sup> allocation in each function depends<sup>on the country,our results suggestthat-mostagencies</sup> would gain by devoting more<sup>attentionto policyadvocacy.</sup> Political visibility and participation<sup>of the privatesectorappear to betwo elementsthat</sup> contribute to the success of<sup>IPAs.Politicalvisibility is best attainedwhenthe agencyis</sup> linked directly to the highest<sup>governmentofficials (e.g.the presidentor theprime</sup> minister). Private sector involvement<sup>can be secured throughparticipationin the board</sup> thalt supervises the agency.

Our paper should be viewed<sup>as a first attemptto examineempiricallytheeffectiveness of</sup> investment promotion agencies<sup>acrosscountriesbecauseit contains obviouslimitations.</sup> Below are proposed three directions<sup>for future research.Thefirst directionwould consist</sup> of completing the data collected<sup>in our survey, notonly by includingmore countries but</sup> also by extending the coverage<sup>period over time.Future researchers,dependingon the</sup> data availability, should carefully<sup>explorethe time lag between overallinvestment</sup> promotion and the decision<sup>of foreign investorsto investin the country.Thistimelag</sup> can vary depending on the country's<sup>conditionsand thefunctionscarriedoutby the</sup> agency.

The second direction should<sup>be to considera morecomplexand realisticobjective</sup> function for the IPAs. Our<sup>approach subscribesto the viewthat IPA's mainobjectiveis</sup> to attract more (foreign) investors.<sup>Such an assumption is certainly correctbut simplistic</sup> 19
> because some agencies assign more emphasis on the quality than the quantity of FDI. This is certainly true for sophisticated IPAs that focus on job creation, exports or technology transfers associated to FDI flows. Along the same lines, one may want to

> explore whether the IPA effectiveness varies depending on the kind of FDI (e.g., sectors,

> reinvested earnings vs. mergers, etc.).

The third and final direction would be to proceed with individual case studies. Our study was aimed at capturing trend across a relatively large set of countries at the expense of details. A complementary approach would be to focus on a few LPAs, with a special attention on their internal characteristics and external environment. Evaluations of their particular promotional techniques (such as image building, investment service, investment generation, and policy advocacy) and of different structures (such as government and quasi-government) should add considerably to the evidence on the influence of promotion on investment flows and to an understanding of the kinds of investors likely to be influenced by promotion efforts.

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