V. FOREIGN DIRECT INVESTMENT: DETERMINANTS, TRENDS IN FLOWS AND PROMOTION POLICIES

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1 V. FOREIGN DIRECT INVESTMENT: DETERMINANTS, TRENDS IN FLOWS AND PROMOTION POLICIES Joong-Wan Cho* A. Globalization and foreign direct investment Globalization is an inevitable and irreversible process, and dealing with the imperatives of globalization capitalizing on its positive aspects and mitigating the negative ones is perhaps the most important challenge for the new millennium. Globalization has enhanced the opportunities for success, but it has also posed new risks to developing countries. Globalization has many faces; however, globalization is first and foremost comprehended in economic and financial terms. In this sense, it may be defined as the broadening and deepening linkages of national economies into a worldwide market for goods, services and especially capital. As a result of a revolution in telecommunications and information technologies, the last 15 years have witnessed dramatic increases in trade linkages and cross-border capital flows, as well as radical changes in the form, structure and location of production. Perhaps the most prominent face of globalization is the rapid integration of production and financial markets over the last decade; that is, trade and investment are the prime driving forces behind globalization. Foreign direct investment (FDI) has been one of the core features of globalization and the world economy over the past two decades. It has grown at an unprecedented pace for more than a decade, with only a slight interruption during the recession of the early 1990s. More * Economic Affairs Officer, Investment and Enterprise Development Section, Trade and Investment Division, Economic and Social Commission for Asia and the Pacific. firms in more industries from more countries are expanding abroad through direct investment than ever before, and virtually all economies now compete to attract multinational enterprises (MNEs). As a result, global flows reached a historic high of US$ 340 billion with the global stock of FDI reaching US$ 3,266 billion in This trend has been driven by the complex interaction of technological change, evolving corporate strategies towards a more global focus and major policy reform in individual countries. The past two decades have witnessed an unparalleled opening and modernization of economies in all regions, encompassing deregulation, demonopolization, privatization and private participation in the provision of infrastructure, and the reduction and simplification of tariffs. An integral part of this process has been the liberalization of foreign investment regimes. Indeed, the wish to attract FDI has been one of the driving forces behind the whole reform process. Although the pace and scale of reform have varied depending on the particular circumstances in each country, the direction of change has not. Most developing countries were starting to look to FDI as a source of capital when flows of official development assistance (ODA) declined sharply in the 1990s. FDI usually represented a long-term commitment to the host country and contributed significantly to gross fixed capital formation in developing countries. FDI had several advantages over other types of capital flows, in particular its greater stability and the fact that it would not create obligations for the host country, as had been observed in the context of the Asian financial crisis of Emerging issues in the areas of foreign direct investment are an essential part of the core process of globalization. Of particular urgency is 99

2 Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific the issue of the quality of the policies that need to be adopted by countries as a result of the growth of FDI and the role it plays in their competitive position in global and regional markets. FDI can play a key role in improving the capacity of the host country to respond to the opportunities offered by global economic integration, a goal increasingly recognized as one of the key aims of any development strategy. B. Foreign direct investment flows: determinants and recent trends 1. Review of host country determinants of FDI Nowadays, virtually all countries are actively seeking to attract FDI, because of the expected favourable effect on income generation from capital inflows, advanced technology, management skills and market know-how. It would be useful to review the key determinants and factors of FDI based on the theories of international investment. Table V.1 lists three key determinants and factors associated with the extent and pattern of FDI in developing host countries: attractiveness of the economic conditions in host countries; the policy framework towards the private sector, trade and industry, and FDI and its implementation by host governments; and the investment strategies of MNEs. The review of host country determinants is closely linked with the role of national policies and especially the liberalization of policies, a key factor in globalization, as FDI determinants. Location-specific determinants have a crucial influence on a host country s inflow of FDI. The relative importance of different location-specific determinants depends on at least three aspects of investment: the motive for investment (e.g., resources, Table V.1. Host country determinants of FDI Markets Size; income levels; urbanization; stability and growth prospects; access to regional markets; distribution and demand patterns. Economic conditions Resources Natural resources; location. Competitiveness Labour availability, cost, skills, trainability; managerial technical skills; access to inputs; physical infrastructure; supplier base; technology support. Host country policies Macro policies Private sector Trade and industry FDI policies Management of crucial macro variables; ease of remittance; access to foreign exchange. Promotion of private ownership; clear and stable policies; easy entry/exit policies; efficient financial markets; other support. Trade strategy; regional integration and access to markets; ownership controls; competition policies; support for SMEs. Ease of entry; ownership, incentives; access to inputs; transparent and stable policies. Risk perception Perceptions of country risk, based on political factors, macro management, labour markets, policy stability. MNE strategies Location, sourcing, Company strategies on location, sourcing of products/inputs, integration integration of affiliates, strategic alliances, training, technology transfer. Source: Sanjaya Lall, Attracting Foreign Investment: New Trends, Sources and Policies, Economic Paper 31 (Commonwealth Secretariat, 1997). 100

3 V. Foreign Direct Investment: Determinants, Trends in Flows and Promotion Policies market or efficiency-seeking), the type of investment (e.g., services or manufacturing), and the size of the investors (small and medium MNEs or large MNEs) (UNCTAD 1998a). As a consequence of globalization and economic integration, one of the most important traditional FDI determinants, the size of national markets, has decreased in importance. At the same time, cost differences between locations, the quality of infrastructure, the ease of doing business and the availability of skills have become more important (UNCTAD 1996). Traditional economic determinants, such as natural resources and national market size for manufacturing products sheltered from international competition by high tariffs or quotas, still play an important role in attracting FDI by a number of developing and developed countries as well as economies in transition (e.g., China, Australia and Kazakhstan). The economic determinants related to large markets, trade barriers and non-tradable services are still at work and account for a large share of worldwide FDI flows. Although FDI remains strongly driven by its traditional determinants, the relative importance of different locational determinants for competitiveness-enhancing FDI is shifting. While low-cost labour remains a locational advantage, the increasingly sought-after advantages are competitive combinations of wages, skills and productivity (UNCTAD 1998a). With the creation of regional integration frameworks (e.g., ASEAN), access to the regional market supersedes access to national markets as an important FDI determinant. This also depends on how well the country is integrated into the regional bloc in terms of policy harmonization as well as physical accessibility, which gives policy determinants an increasing importance. For foreign investors, the host country policies on the repatriation of profits and capital and access to foreign exchange for the import of intermediaries, raw materials and technology are particularly important. The pattern of recent FDI flows supports the conclusion that liberal policies on technology, which tend to go hand in hand with more liberal policies in general, serve to attract more and better foreign investments. Core FDI policies consist of rules and regulations governing the entry and operations of foreign investors, the standards of treatment accorded to them and functioning of the markets within which they operate (UNCTAD 1997). Among the supplementary policies used to influence locational decisions, trade policy plays the most prominent role. Asian countries have used both FDI and trade policies to encourage MNEs to contribute to their export-oriented development strategies. Other related policies may include privatization policies and policies determined by international agreements, such as bilateral investment treaties (BITs). BITs augment the international dimension to national direct investment policies focused on insurance and protection and other broader issues. However, as in the case of BITs, it is precisely the function of the enabling framework to allow other determinants, especially economic determinants, to assert their influence. 2. Summary of recent trends in FDI flows After a decade of steady and strong growth, foreign direct investment flows declined sharply in 2001 and continued their decline in 2002, decreasing further by 27 per cent. In 2002, the volume of FDI inflows reached about US$ 534 billion, which contrasts with US$ 735 billion in 2001, and is equivalent to a third of the US$ 1,492 billion peak in 2000 (see table V.2). A major factor behind this decline is the slowdown in the world economy, which has reduced world demand and accentuated and accelerated the global restructuring process of major MNEs in sectors characterized by excess capacity. The decline in FDI in 2001 also reflects the aftermath of the 11 September 2001 incident. The decline in 2001 was mainly concentrated in developed countries as a result of a considerable drop in cross-border mergers and acquisitions (M&As). FDI inflows to developed countries decreased by 59 per cent, compared with 14 per cent in developing economies. In 2002, similar trends continued with a major decline in developed countries and a smaller decline in developing countries. FDI in 2001 was higher than that in 1998, after which dramatic increases 101

4 Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific Table V.2. FDI inflows by region, (Billions of US$) Host region World a a a a a Developed economies (56.0) b (69.7) b (77.0) b (82.3) b (68.4) b Developing economies (39.9) b (27.0) b (20.7) b (15.9) b (27.9) b Africa (5.6) c (4.8) c (5.7) c (3.7) c (8.4) c Asia and the Pacific (55.5) c (51.4) c (45.8) c (56.2) c (49.9) c Latin America and the Caribbean (38.9) c (43.8) c (48.5) c (40.1) c (41.7) c Central and Eastern Europe (4.0) b (3.3) b (2.3) b (1.8) b (3.7) b Source: World Investment Report 2002: Transnational Corporations and Export Competitiveness (UNCTAD/WIR/2002). a Including FDI inflow figures of least developed countries and oil exporting countries. b Percentage share of the world total. c Percentage share of the developing economies total. in cross-border M&As led to record flows in 1999 and This is the third downward cycle in FDI since the late 1980s, which reflects such short-term factors as business cycles, portfolio investment sentiment and M&As, which work in parallel with longer-term factors (UNCTAD 2002). The economic slowdown has intensified competitive pressures, forcing companies to search for cheaper locations. This may have resulted in increased FDI in activities that benefit from relocation to low-wage economies. FDI outflows may also have risen from countries in which domestic markets have been growing slower than foreign markets. There are signs that both factors have contributed to the recent increase of Japanese FDI in China. In general, there has been a redistribution of FDI towards developing countries, where growth has reportedly been higher than in developed countries. The rise in developing countries shares may also reflect the further liberalization of their FDI regimes, which was reinforced by the growth in the number of bilateral investment promotion and protection treaties. In spite of the substantial liberalizing measures of the 1990s, developing countries still attract less than a third of world FDI flows, and these flows remain highly concentrated. In 2001, the five largest host countries in the developing world received 62 per cent of total inflows. The decline in FDI flows in 2001 largely reflects a fall in cross-border M&As, the principal vehicle since the mid-1990s for FDI in developed countries. It could be argued that 2001 saw a return of FDI to normal levels after the surge of M&A activities in the period In developing countries and economies in transition, FDI in 2001 in fact proved fairly resilient despite the global downturn and the 11 September 2001 incident. This resilience was more pronounced in comparison with inflows of portfolio investment and bank lending. On a net basis (inflows less outflows), FDI flows were the only positive component of private capital flows to developing countries and economies in transition during (UNCTAD 2002). It is worthwhile to note that FDI in developing countries has been larger than official inflows since It was 10 times larger than bilateral 102

5 V. Foreign Direct Investment: Determinants, Trends in Flows and Promotion Policies ODA in This contrasts with the latter half of the 1980s, when the two were about equal. It needs to be stressed, however, that for the least developed countries, ODA remains of paramount importance. 3. FDI inflows to the Asian and Pacific region FDI flows to the developing economies of Asia and the Pacific declined from US$ 134 billion in 2000 to US$ 102 billion in Much of the decline was due to an over 60 per cent drop in flows to Hong Kong, China, which had recorded a massive inflow of US$ 62 billion in 2000 (see table V.3). FDI flows to China, the largest recipient among the developing countries for most of the 1990s, regained their momentum after three years of stagnation, to reach US$ 47 billion in The upward trend in FDI is likely to be sustained in the coming years, particularly in the light of the country s accession to WTO in November In addition to investment by new entrants, reinvested earnings of foreign affiliates in China have become an important source of FDI, accounting for about one third of the total inflows during FDI continues to play a prominent role in China s economy. For example, foreign affiliates now account for 23 per cent of the total industrial value added, 18 per cent of tax revenues and 48 per cent of total exports (MOFTEC 2001). Table V.3. FDI inflows to the Asian and Pacific region, (Millions of US$) Host subregion/economy Asia and the Pacific Asia West Asia Islamic Republic of Iran Turkey Central Asia Azerbaijan Kazakhstan South, East and South-East Asia China (41.7) (45.4) (39.1) (30.5) (45.8) Hong Kong, China (10.7) (15.3) (23.9) (46.3) (22.3) India Indonesia Malaysia Philippines Republic of Korea Singapore Thailand Pacific Fiji Papua New Guinea Source: Notes: World Investment Report 2002: Transnational Corporations and Export Competitiveness (UNCTAD/WIR/2002). Figures in parentheses ( ) denote percentage share of the regional total. Negative figures denote disinvestment. 103

6 Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific Turning to North-East Asia, the FDI boom has subsided with inflows falling from US$ 76 billion in 2000 to US$ 30 billion in FDI in the Republic of Korea fell by some 67 per cent in 2001 to US$ 3 billion as the surge of post-financial crisis M&As subsided. Flows to South-East Asia stagnated at US$ 13 billion; part of the reason was continued divestment (US$ 3 billion in 2001) in Indonesia, where divestments have exceeded FDI inflows since late In Malaysia, FDI remained stagnant, whereas inflows to the Philippines rose from US$ 1.2 billion in 2000 to US$ 1.8 billion in FDI in Singapore also increased by 59 per cent to US$ 9 billion, the first time since 1998, but still below the peak of US$ 11 billion reached in Faced with the erosion of its competitiveness in electronics vis-à-vis other countries in the region, Singapore has designated the biomedical industry as the next pillar of its growth area, and has been improving infrastructure and targeting high-potential companies in that industry through various investment funds, including venture capital. FDI in Thailand increased by US$ 1 billion to US$ 3 billion and the MNEs continued to consolidate their regional auto-manufacturing bases in Thailand. Viet Nam is entering a new era as host to FDI strengthened by the bilateral trade agreement with the United States, and the prospect of its accession to WTO. Inflows into South Asia reached US$ 4 billion, a 32 per cent increase over Out of the subregion s total FDI, US$ 3.4 billion went to India, a 47 per cent increase over the previous year. India, which is by far the largest recipient in the region, has been taking steps to liberalize its FDI regime further. Inflows into other economies in the subregion stagnated or declined apparently owing to perceived instability in the investment environment, particularly after the 11 September 2001 incident. FDI in Central Asia rose by 88 per cent in 2001, to US$ 3.6 billion, driven by the doubling of inflows into Kazakhstan (US$ 2.8 billion). Resource-based activities, particularly in copper and zinc as well as in oil and gas extraction, took up the largest share (77 per cent) of inflows into the subregion. The Pacific region remains marginal in terms of FDI inflows, with US$ 200 million in Political instability coupled with relatively poor infrastructure added to the structural constraints of location and size in the Pacific island countries. Overall, the prospects for FDI in the Asian and Pacific region remain bright. Surveys suggest Asia will continue to be an important location for the expansion of the international production system, where China topped the list in Asia, followed by Indonesia and Thailand. Greenfield investment will once again become the preferred option by far for FDI entry into the region following the M&A boom during the financial crisis (MIGA 2002). C. Host country FDI promotion policy trends Recently, the FDI inward policy regimes of most countries around the world, both developed and developing, have taken on a liberal framework. The liberalization of core FDI policies consists of reducing barriers for inward FDI, strengthening standards of treatment for foreign investors and ensuring the proper functioning of markets and a level playing field for all investors. Ironically, with policy regimes becoming increasingly open and similar, many countries have found that they need to make further efforts to attract FDI in such a competitive climate; FDI is now recognized as one of the most important sources of muchneeded capital and managerial, technical and marketing know-how not only in the manufacturing industry, but also in services and the resourcebased industry. Moreover, world-wide liberalization convergence increases the locational choice for FDI. Measures aimed at attracting FDI are not always sufficient to ensure the greatest possible benefits that countries expect from FDI, such as technology transfer to foreign affiliates and domestic firms, more and deeper linkages with local enterprises, higher exports, higher employment and upgraded skills. At the same time, host countries seek to reduce any negative effects related to 104

7 V. Foreign Direct Investment: Determinants, Trends in Flows and Promotion Policies foreign investment, such as financial volatility, anti-competitive practices, abusive transfer pricing, the crowding-out of domestic firms and excessive dependence on foreign ownership. In brief, for host countries the central concern is to maximize the positive effects of FDI and minimize its negative effects. When considering what host country policies could effectively help developing countries and economies in transition to attract FDI and benefit from it, a wide range of host country policy measures were implemented, for example, to: Create a sound and stable macroeconomic and political environment, including a transparent and predictable business environment Develop physical and technical infrastructure, and promote clusters Develop human resources Develop domestic enterprise capabilities, especially SMEs Address environmental and social concerns Adopt competition laws and reduce restrictive business practices Influence the behaviour of investors by offering investment incentives and imposing performance requirements Create larger markets through regional and bilateral cooperation Protect investment, including intellectual property rights Countries have implemented active FDI promotion policies that have evolved over the years, as the objective has shifted from simply attracting a desired quantity of FDI to attracting quality FDI with a highly beneficial impact on the domestic economy. In the first generation of investment promotion policies, many countries adopt market-friendly policies. They liberalize their FDI regimes by reducing barriers to inward FDI, strengthening standards of treatment of foreign investors and assigning a greater role to market forces in resource allocation. Some countries can go a long way in attracting foreign investment with these steps, if the basic economic determinants for obtaining FDI are right. On the issue of FDI performance requirements and effectiveness, almost all countries, both developed and developing host countries, have had recourse to such requirements at some stage in their development. Specific objectives for the use of performance requirements include: Deepening and broadening of the industrial base Generation of employment opportunities Linkage promotion Export generation and performance Trade balancing Regional development promotion Avoidance of restrictive business practices Technology transfer Strong local firms attract FDI; the entry of foreign affiliates, in turn, enhances the competitiveness and dynamism of the domestic enterprise sector. The strongest channel for diffusing skills, knowledge and technology from foreign affiliates is backward linkages with local firms. This can contribute to the growth of a vibrant domestic enterprise sector, the foundation of economic development. Foreign affiliates, in turn, can benefit from backward linkages as they reduce costs and enhance access to local tangible and intangible assets. Hence there is a substantial mutual interest between foreign affiliates and domestic firms in creating and deepening backward linkages. With respect to the technology transfer requirement, technology and knowhow flowing from parent firms to their foreign affiliates are one of the principal channels for international technology transfer. MNEs are the repositories of much of the world s most advanced technologies, and most technology transfer takes place within the MNEs. Intrafirm payments of royalties and licence fees account for the 105

8 Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific majority of the total sales of these transactions. More competition in host country markets increases the pressure and incentives for MNEs to transfer more and better-quality technology to affiliates. In a globalizing economy, however, performance requirements are used less frequently, because they are increasingly considered an unnecessary bother, which might discourage foreign investors. In contrast, the use of investment incentives has proliferated. Sometimes countries even engage in direct competition for specific investment projects with financial and other incentives, and such competition can be very costly. In spite of this competition, there is considerable evidence to suggest that incentives are a relatively minor factor in the location decisions of MNEs relative to other locational advantages. Countries have used various policies and measures to attract FDI and increase the benefits from it, from targeted promotion policies to incentives and performance requirements, as well as measures to support the enterprise sector. Many of these measures, however, have been subjected to new international rules in the framework of multilateral agreements such as the WTO Agreements on TRIMs and on Subsidies and Countervailing Measures (SCMs). For example, local content requirements have been phased out by most countries in line with the requirement of the TRIMs Agreement. At the same time, FDI and trade liberalization, as well as more intense competition for FDI, have reduced the reliance on other investment performance requirements. In the second generation of investment promotion policies, Governments actively seek to attract FDI by marketing their countries, which usually leads to the setting-up of national investment promotion agencies (NIPAs). The third generation of investment promotion policies takes as a starting point the enabling framework for FDI and a proactive approach to attracting FDI. It then proceeds to target foreign investors at the level of industries and firms to meet their specific developmental priorities, for example, in export promotion or linkage creation. The key to the success of these new investment promotion strategies is that they actually address one of the basic economic FDI determinants while understanding the changing locational strategies of MNEs. Regardless of the level at which FDI is promoted, the competitiveness of the domestic enterprise sector and a pool of skilled people are the keys to the product to be marketed. Another important element of targeting is a sound analysis of MNEs strategies affecting the choice of location. In response to the increased geographical and functional specialization in many industries, countries may find it useful to identify production niches through which they can link up with international production systems. There are, however, risks involved in developing a more targeted and focused strategy. Resources may be focused on attracting investments that do not materialize, or considerable efforts and resources may be devoted to seeking the wrong types of firms, or firms that would have invested in any event. Improving the overall policy environment for investment should not be sacrificed to a selective focus on attracting a few firms. Also, for most developing countries, the investors to target will probably not be the largest MNEs in the world, but smaller firms within the appropriate industry or activity. Although adopting an investor-targeting strategy can clearly be effective in attracting FDI, it presents considerable challenges for Governments. Effective targeting requires business-oriented NIPAs with welldeveloped links to the private sector as well as other branches of government, to identify and create comparative advantages that are sustainable (UNCTAD 1997). In today s highly competitive world economy, the ability to attract FDI, especially highquality FDI, increasingly needs an investment product. One implication of this is that countries that want to attract high-quality FDI and benefit from it need to develop differentiated and efficient clusters that offer real and identifiable locational advantages to international investors and eventually become brand names recognizable to any national or international investor seeking this particular configuration of advantages. Bangalore in India has such a brand name for the 106

9 V. Foreign Direct Investment: Determinants, Trends in Flows and Promotion Policies development of software, as do Singapore and Hong Kong, China, for financial services and regional headquarters. It must be recognized, however, that such a targeted approach, and especially the development of a locational brand name, is difficult, costly and takes time. Moreover, a more targeted and fine-tuned approach, which in the end seeks to match the specific functional needs of corporate investors with specific locational products, requires fairly sophisticated institutional capacities. It is, however, facilitated by the proliferation of sub-national agencies, and also even by municipal investment promotion agencies that as a rule, seek to market more specific investment products. But this gives rise to another challenge: the need to coordinate polices across various administrative levels in a country. Proper consultation and coordination mechanisms between central and provincial or municipal governments need to be strengthened for proper and efficient investment attraction (ESCAP 2002). In sum, the continuous need for countries to move up the ladder and improve the attractiveness of their locational advantages is a challenging task for policy makers in developing countries and calls for sophisticated and comprehensive policy approaches. Regardless of the level at which FDI is promoted, and regardless of the precise mix of the three basic investment promotion strategies pursued, the competitiveness of the domestic enterprise sector, including a pool of skilled people, is the key to the investment product. Investment facilitation measures Host Governments have a choice between allowing in foreign investment without specific approval or subjecting proposed investment to screening and approval against specific criteria. While the trend to creating a more enabling FDI framework continues, many countries still evaluate and screen FDI at the point of entry. The time required to obtain the various licences, permits and approvals needed can sometimes be considerable and can negatively influence the cost-efficiency of a location; the cost in terms of both money and time are especially important to export-oriented foreign investors. Investment and business facilitation measures include promotion efforts, provision of incentives to foreign investors, reduction of unnecessary costs of doing business in a host country (e.g., reducing or eliminating corruption and improving administrative efficiency) and provision of amenities that contribute to the quality of life of foreign investors and expatriates. Investment facilitation services are another increasingly important component of promotion activities in both developed and developing countries. Such services consist of counselling, accelerating the various stage of the approval process and providing assistance in obtaining all the permits needed. Under the pressures of competition for FDI in a globalizing economy, investment facilitation measures and services have been extended to include after-investment services. Sequential investment, the reinvestment of earnings by established foreign affiliates, can be a significant source of FDI; also there is a growing awareness that satisfied investors are the best evidence of a good investment climate in a host country and that they can therefore help to attract other investors. Countries compete increasingly for FDI not only by improving their policy and economic determinants but also by implementing pro-active investment facilitation measures that go beyond policy liberalization. Successful attraction of FDI should also be followed up by efficient facilitation and implementation of investment projects and by ensuring that local investment regulation and procedures are consistent with the central government policies, laws and regulations (ESCAP 2003). NIPAs can reduce administrative barriers by fostering the development of industrial and export processing zones. In addition to good infrastructure and tax incentives, such zones can constitute islands of administrative efficiency and provide a buffer between export-oriented foreign investors and regulatory authorities. NIPAs can also help to ensure the relevant laws and regulations governing export-oriented FDI are easily accessible by foreign investors. Increased 107

10 Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific transparency of the administrative system and investment procedures makes it easier for foreign investors to predict costs for the realization of investment projects. A range of instruments could be applied to improve public governance, including performance assessments, e-government and codes of conduct for the officials at NIPAs and other investment-related government agencies. One way for NIPAs to attack regulatory inefficiencies and red tape is to develop so-called investor road maps. These have been developed by the Foreign Investment Advisory Service (FIAS) as a tool for identifying and reducing the number and scope of procedural steps, regulatory requirements and administrative barriers that constitute the day-to-day interactions between government and entrepreneurs (FIAS 2001). The number of agencies whose supervision, approval or other input is required in the investment process presents a Government with a substantial risk of coordinating/avoiding duplication for each phase of the promotion strategy, including image-building, generating specific projects and, most specifically, facilitation services relating to screening, approvals and follow-up. To address this problem, there is a strong need to launch an initiative to assist developing economies in their efforts to promote good governance in investment facilitation, which could be measured by the efficiency and transparency of investmentrelated procedures and practices. Establishment of an office of an investment ombudsman at the national level (for example, in the case of the Republic of Korea) could be part of a good governance programme in investment promotion and facilitation for other developing economies to consider and adopt. D. FDI by small and medium enterprises In a liberalizing and globalizing world economy in which all enterprises, whether large or small, are increasingly subjected to international competition, the internationalization of SMEs, through both inward and outward investment, deserves increasing attention, as these firms play a central role in economic development. SMEs constitute an important part of the economies of most Asian countries, contributing substantially to employment and production. They can also make a major dynamic contribution to growth and development. Internationalized SMEs, in particular, offer a significant potential source of growth and development for developing countries. For example, smaller MNEs are more likely to: (a) transfer appropriate technology to developing countries; (b) have a favourable impact on the trade balance; and (c) have more flexible local arrangements and contribute more to the local economy by using subcontracting to a greater extent (UNCTAD 1998b). SMEs contribute to development in two main ways: Through conventional contributions via the normal production process, such as investment in tangible and intangible capital and technological processes. The contribution of SMEs in this way is probably relatively small, and roughly in proportion to the role of SMEs in production or value added, around 40 to 60 per cent in the leading Asian economies. Through the less conventional entrepreneurial engine. In developed countries at least, SMEs contribution to growth is larger than might be suggested by conventional models, and mostly comes from a relatively small proportion of high-growth SMEs. SMEs engaged in FDI are more likely to be among this core group of highgrowth firms. It is important to take this fact into account in the design of policies to facilitate FDI for development. The process of SME internationalization, especially through SME FDI, can offer significant opportunities for development. FDI by SMEs has grown remarkably since the mid-1980s. Driven, among other factors, by the need to be present abroad to access markets 108

11 V. Foreign Direct Investment: Determinants, Trends in Flows and Promotion Policies and resources in order to maintain their competitiveness in a rapidly liberalizing and globalizing world economy, small and medium MNEs are increasingly internationalizing their production activities. FDI by SMEs thus complements large MNEs as a potential avenue for the transfer of productive resources and technology that can enhance the growth and competitiveness of developing countries. As a case in point, the first wave of Japanese investment abroad, in the 1960s, was led by small and medium firms seeking low wage bases overseas. In the 1970s and 1980s, it became dominated by large manufacturers, seeking natural resources, production sites in or near large export markets and low-cost assembly sites for labour-intensive processes in South-East Asia. The current wave is led by support industries, which produce parts and machinery for the big manufacturers and are finding it increasingly expensive to supply components from their home base (Fujita 1998). Most SMEs face several handicaps in investing in developing countries. They lack information on investment opportunities and local conditions, they are particularly sensitive to political risk and macroeconomic uncertainties and they are unfamiliar with the different legal systems and regulations involved. Apart from the right policy environment, with stable and nondiscriminatory policies and good market prospects, the promotion of FDI by SMEs has to address the information gaps and risk elements that are inherent in the internationalization of small firms. Many developing host countries are already making efforts to do this. A number of countries do not require formal approval for FDI below a certain size. Several that had requirements regarding the minimum size of foreign investments have abolished them: Malaysia, Thailand and Indonesia are good examples. The Republic of Korea has reduced the minimum size requirements over time. The reduction of clearance formalities is being achieved by the setting-up of one-stop agencies for FDI promotion. Policies used by developing countries to help SMEs in general, such as lower tax rates and credit, infrastructure and other forms of assistance on favourable terms, can also help SME MNEs if their entry is facilitated in other ways. Entry into overseas markets by SMEs also has been facilitated by a new array of costsaving and risk-reducing investment techniques, allowing foreign companies to take effective control and expand production abroad without majority equity stakes or ownership control in the venture. Such techniques include joint ventures, international subcontracting deals, licensing arrangements, franchising, management contracts, turnkey projects, and production and risk-sharing agreements. These new forms of investment reduce the start-up and working capital costs of investments, limit MNEs exposure to political and commercial risks and allow them to circumvent administrative barriers to market entry, without losing competitive strength (Oman 1984). In sum, SMEs that engage in FDI are an important part of the entrepreneurial engine that drives development and growth. In many developing countries, however, the SME sector is insufficiently developed in terms of the core of dynamic and fast-growing SMEs that contribute significantly to development. FDI by SMEs has the potential to strengthen the SME sectors of home as well as host countries, contributing to the health and dynamism of their economies. The potential in this regard is high, as more than 95 per cent of all firms are small or medium-sized. Increasing the awareness and understanding in developing countries of this insufficiently tapped source of investment can thus usefully contribute to their development, including the development of their own SMEs. Carefully designed policies are, however, needed to encourage FDI by and in SMEs. A number of countries have considerable experience as regards SME development generally as well policies to attract investment by such enterprises and to expand and strengthen its role in development. An understanding of this experience would be useful in formulating policies and programmes with respect to attracting and benefiting from FDI by SMEs, since developing Asia has a larger potential to mobilize FDI by SMEs than any other developing region. Asian SMEs are likely to be among the primary sources of future Asian development. For this to be realized, appropriate, enhanced Asian linkages have to be established at all levels. 109

12 Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific E. Conclusions and implications for regional action and cooperation FDI inflows could bring important benefits to the recipient economies in the form of capital inflows, technology spillovers, human capital formation, international trade integration, enhancement of enterprise development and good governance. However, FDI could have negative effects in such areas as market structure and balance of payments and could lead to crowding-out of domestic enterprises, as well as other social impacts. Government policies are therefore needed to enhance benefits and minimize negative effects. The role of an enabling environment for FDI including political stability as a key factor in attracting and maintaining investors cannot be overemphasized. Another universally acknowledged principle is the need to offer stable, transparent and non-discriminatory regimes for foreign investors. Such an environment would consist, among other things, of a legal framework maximizing a country s potential for attracting FDI, adequate infrastructure, good governance, an effective judicial system and respect for the rule of law. The policy mix has to be adapted to the special circumstances prevailing in different countries and might have to evolve over time. Factors influencing this mix are level of development, market size, domestic capabilities and existing levels of FDI. Globalization offers better opportunities for small economies to compete for export-oriented FDI, but it also implies more competition between countries. Hence, it is becoming increasingly important for countries to consider what the best policy approach is for attracting and benefiting from FDI in accordance with their development objectives. Even at an early stage of their development, countries need to attach importance not just to the size of FDI, but also to its qualitative aspects. Concerns have arisen that competition to attract FDI will intensify among countries, especially the type of FDI that can bring major benefits to recipient economies by enhancing their export competitiveness or by providing linkages with domestic enterprises. Indeed, countries are increasingly recognizing the positive contribution that FDI can make to economic development through an increase in export capacity, employment generation, transfer of technology, industrial upgrading and training of labour. In this kind of international investment environment, there is a great need to strengthen the capacity of host countries, particularly developing countries, in dealing with FDI inflows. This involves devising FDI policies and enhancing legislative and institutional structures in order to attract new investment and building new skills and capacity by training policy makers, officials, managers and local entrepreneurs as regards what they can offer foreign investors and how to attract and assist them in FDI realization. While most multilateral organizations concentrate on promotion and attraction of FDI, relatively little has been done in the area of investment facilitation and realization, which is of particular concern for the further promotion of investment. There seems to be a strong need to fill this gap in investment facilitation and realization within an effective framework of FDI promotion policies, especially at the SME level, such as: Promoting the exchange of experiences and the transfer of best practices and establishing regional networks Enhancing FDI flows in small and medium industries (SMIs) by organizing investment promotion and facilitation meetings at certain intervals, keeping in view the needs and priorities of the host countries in the region Providing regional perspectives on emerging issues related to FDI and SME capacity-building and undertaking studies in those areas for the harmonization of investment policies and strategies. There is considerable scope for the harmonization of the laws and regulations, property rights, equity sharing and other requirements related to FDI 110

13 V. Foreign Direct Investment: Determinants, Trends in Flows and Promotion Policies Countries have used various proactive policies and measures to attract and increase the benefits from FDI, ranging from targeted promotion policies to incentives and performance requirements, as well as measures to support the enterprise sector. Many of these measures, however, have been subjected to new international rules in the framework of multilateral agreements such as the WTO Agreements on TRIMs and SCMs and other regional or bilateral agreements. The challenge for policy makers is to deepen their understanding of what policies and policy tools are most important from a development perspective and how international rules in the area of investment would affect them. Finally, while SME MNEs remain relatively small players in the global FDI scene, their importance should not be underestimated in the long term. They are bound to become more international as the pace of globalization increases. They can offer simple technologies and can diffuse skills and know-how to local enterprises more readily than large MNEs. In this context, the following agenda for regional action and cooperation could be envisaged: Regional information networking on FDI opportunities in the SME sector of the region SME-specific measures, such as an SME investors club which will focus attention on SMEs and provide supporting activities by government agencies, private industry and other SMEs Provision of a regional training programme for members and associate members to evolve comprehensive investment promotion and facilitation policy measures, especially at the SME level Design and implementation of good governance programmes in investment promotion and facilitation at the regional and/or subregional level 111

14 Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific REFERENCES ESCAP, Report of the High-level Subregional Seminar on Investment Promotion and Realization for Indo-China, Hanoi, 5 March 2002., Report on the Regional Round Table on FDI for Central Asia, Dushanbe, 3-4 April FIAS, Investor Road Maps (Washington, World Bank Group and International Finance Corporation Foreign Investment Advisory Service). Fujita, Masataka, The Transnational Activities of Small and Medium-sized Enterprises (New York and Dorecht, Kluwer Academic Publishers). Lall, Sanjaya, Attracting Foreign Investment: New Trends, Sources and Policies, Economic Paper No. 31 (Commonwealth Secretariat). McIntyre, Robert, The Role of Small and Medium Enterprises in Transition: Growth and Entrepreneurship (Helsinki, United Nations University World Institute for Development Economics Research). MIGA, Foreign Direct Investment Survey (Washington, World Bank Group, Multilateral Investment Guarantee Agency). MOFTEC, Achievements in FDI utilization and the role of FDI in China (Beijing, Ministry of Foreign Trade and Economic Cooperation). Oman, C., ed., New Forms of International Investment in Developing Countries (Paris, OECD Development Centre). UNCTAD, World Investment Report 1996: Investment, Trade and International Policy Arrangements (UNCTAD/WIR/1996)., Survey of Best Practices in Investment Promotion (UNCTAD/ITE/IIP/1)., 1998a. World Investment Report 1998: Trends and Determinants (UNCTAD/WIR/ 1998)., 1998b. Handbook on Foreign Direct Investment by Small and Medium-Sized Enterprises: Lessons from Asia (UNCTAD/ ITE/IIT/6)., World Investment Report 1999: Foreign Direct Investment and the Challenge of Development (UNCTAD/WIR/ 1999)., World Investment Report 2002: Transnational Corporations and Export Competitiveness (UNCTAD/WIR/2002). 112