Lessons of Experience No. 5: Foreign Direct Investment

Foreign investment in the form of loans or equity is an important source of capital for growth in developing countries. Equity investments can be either indirect (portfolio) or direct, known as foreign direct investment (FDI). FDI does much more than provide developing countries with financing for their growth. It brings them new technologies, management techniques, and market access as well. FDI may be stimulated by exploitation of proprietary technology or natural resources or by access to markets.

The Role of FDI in Developing Countries

Foreign direct investment in developing countries has a long history. It has fluctuated over time, as investors have responded to changes in the environment for investment, including government policies toward foreign direct investment and the broader economic policy framework. Hence, trends in FDI have reflected changes in policy stances by developing countries, from import substitution in the 1950s and 1960s through natural resource-led development in the 1970s, structural adjustment and transition to market economies in the 1980s, and an increased role for the private sector in the 1990s.

FDI in developing countries has flowed mainly into manufacturing and processing industries. It has traditionally been concentrated in a small group of countries, which partly reflects the size of their economies and partly their attractiveness as a location for FDI. In the past, attractiveness has been closely linked to possession of natural resources or a large domestic market. With the shift toward globalized production and trade, competitiveness as a location for investment and exporting has become the main determinant of attractiveness. The largest developing-country host for FDI is China, but Eastern Europe has emerged as an important new location for FDI. FDI has also reached the poorest countries. Although the actual amounts invested are generally low, reflecting the small size of their economies, FDI flows relative to GDP in poorer countries are as high as in richer countries. Countries in South Asia and Sub-Saharan Africa, however, lag behind in the volume of FDI flows relative to GDP.

For a long time, FDI came almost exclusively from the major industrial countries. Recently, the sources of FDI in developing countries have widened, and many developing countries have emerged as sources in their own right, particularly for their own regions. Regional links are also important for FDI from developed economies.

Recent trends toward globalization of production and consumption patterns have led to a sharp increase in global FDI. At the same time, trade and investment liberalization has brought more developing countries into the globalized economy. This has led to a dramatic surge in FDI flows to developing countries, which increased fivefold from 1990 to 1995, and exceeded $100 billion in 1996. This increase went mainly to 12 large developing countries, in part reflecting their economic size. Thus, China alone received $167 billion between 1990 and 1996 (1996 prices). Already a significant part of the economy in many developing countries, FDI is likely to continue at high levels for the foreseeable future.

Policies have also played a role in this increase. India, the next largest developing country after China (measured by population), received only 0.2 percent of GDP in FDI inflows, compared to China's 5.4 percent of GDP. Since both are populous, low-income countries, differences in population or income level do not explain this disparity. Prior to 1982, India had received more FDI in relation to GDP than China. What changed was China's policy stance toward foreign investors. After years of strictly regulating FDI, China began to see that it could make a welcome contribution to modernization and integration into the world economy. This was reflected in a changing policy framework, to which foreign investors responded quickly. Since 1992, however, India's steps toward economic liberalization have also had a positive impact on FDI flows and are indicative of its future potential.

FDI is not just attracted to the economic giants, with large domestic markets. Countries of all sizes at different stages of development from all over the world have attracted FDI worth more than 5 percent of GDP, including Czech Republic and Malaysia. What they had in common was an evolving policy framework that was attractive to foreign investors.

Promoting FDI Through Policy Advice

IFC was established to promote private investment in developing countries, including FDI. It was one of many international initiatives that promoted FDI, including bilateral trade agreements, bilateral and multilateral financial institutions, and investment promotion programs. Together with other members of the World Bank Group, IFC set up the Foreign Investment Advisory Service (FIAS) in 1989 to advise developing countries on policies to promote FDI. Since then, it has assisted more than a hundred countries in various ways. Its advice takes many forms, from diagnostic studies giving an overview of constraints to FDI, to investment policy studies giving specific solutions for specific issues or sectors or for building institutions to accompany policy change and promotional strategies. Dialogue on the policy framework for FDI also occurs in the context of other IFC advisory work and project financing.

Getting the Policy Environment

Right Many factors influence the flow of foreign direct investment to developing countries, but the most obvious one is often overlooked: namely, the willingness of developing countries to allow it. Historically, many countries have placed onerous limitations on the scope for FDI, even when seeking to promote it. Inevitably, this has acted as a deterrent.

Restrictions on inflows of FDI have taken many forms, including limits on entry to certain sectors, complex approval mechanisms, high taxes and complex incentive regimes, restrictions on share of foreign ownership, and restrictions on use of land and expatriate labor. Restrictions have been imposed for many reasons, including concerns over excessive foreign influence and loss of national wealth, desire to promote indigenous entrepreneurship and workers, and desire to achieve transfer of technology and management techniques. Only fairly recently have a number of developing countries reduced their restrictions.

Wider policies also matter. A liberal trade and payments regime encourages FDI. Often, imports lead to investment and production for the world market. Liberal payments systems allow foreign investors to take advantage of these opportunities. A number of other administrative barriers, often long unrecognized, have deterred FDI. Important barriers include the exclusion of foreign investors from land ownership, restrictions on the use of expatriate labor, and requirements for sundry permits and approvals.

A large state role in the economy can also deter FDI, whether through price controls, methods of capturing rents from natural resource exploitation and monopolies, or through the presence of a large state enterprise sector. Privatization methods can have a large direct impact on FDI inflows, as can the structure of direct sales and the sales process. Privatization can have positive indirect effects on FDI, too. Although very high effective tax rates can deter FDI (and some investments are particularly sensitive to tax rates), selective incentives can be both costly and ineffective in attracting FDI. Attempts to foster domestic linkages with foreign enterprises have generally been counterproductive, too.

Finally, getting policies right may not be enough; active investment promotion may be required as well, unless the domestic market is sufficiently attractive to FDI. Effective promotion involves image building, investment generation and investor servicing to influence investment decisions. Needless to say, promotion without good policies will not work.

Promoting FDI Through Project Finance

IFC has invested in developing countries in every part of the world since 1958, in more than five hundred companies that have foreign investors. IFC's investments have been spread broadly among countries, even the poorest countries. The Corporation has been an early investor in new and risky locations for FDI and has worked with investors from many different countries supporting FDI in a wide range of sectors. Sometimes, even the largest multinationals have found benefits in cofinancing with IFC, and developing-country governments have often welcomed IFC's presence in a venture.

IFC's projects have been largely successful and profitable, despite sometimes difficult investment conditions. Two thirds of the projects financed have been foreign sponsored, and nearly two thirds of them have been structured as joint ventures with local partners. In these, the foreign sponsor is usually responsible for day-to-day management or technical support. A fifth of the projects have local sponsors, who bring in foreign partners to provide access to technology, management expertise, or marketing support. Projects with equal stakes between foreign and local partners have done relatively poorly.

Until the 1980s, most IFC foreign direct investment projects took place in highly regulated economies, which influenced the relative attractiveness of production for domestic and export markets. As a result, few FDI projects were based on international competitive advantage. Instead, they were oriented toward producing for protected domestic markets or exploitation of developing countries' natural resources. There were no investments in nontradables such as infrastructure. The policy environment also influenced the ownership structure of projects, with few wholly foreign-owned ventures. These patterns are reflected in the types of product and the country locations and affect the pattern of project performance. Projects have done better in open than in protected markets and better still with contractual marketing arrangements.

Since 1980, a marked shift has occurred in the composition of IFC's foreign direct investment portfolio, one that has accelerated in the 1990s. Projects are increasingly based on production for global markets or provision of nontradables, and reliance on contractual marketing arrangements has grown. Foreign control has increased, with more projects majority owned by foreign investors, and more wholly foreign-owned projects. Privatization has brought foreign investors into many previously local enterprises. This is reflected in the changing country composition of the portfolio, the changing sectoral composition, and the improved performance of the more recent portfolio.

Getting Project Structures Right

The structure of IFC's foreign direct investment projects reflects the policy constraints under which they were formed, with most taking the form of joint ventures. Though a common form of business organization, joint ventures are inherently fragile. Forced partnerships are more difficult to implement, particularly when they are with public enterprises, and equal partnerships have been problematic. Limits on foreign ownership have impeded effective project structures, too. They have sometimes had the effect of reducing sponsor commitment to meet additional costs or to resolve management problems. They have also encouraged foreign sponsors to find alternative means to profit from the venture. FDI project structures are also affected by restrictions on capital transfers. FDI projects have been vulnerable to delays and cost overruns, including those generated by extensive government regulation. Close regulation of FDI projects reduces their flexibility to respond to developments.

With careful project design, however, joint ventures can be implemented successfully. It is important to ensure appropriate management arrangements through, for example, a management contract; clear financing arrangements; and careful handling of each partner's interests as a contractor with the enterprise or as a holder of related assets.

Getting More From FDI

Governments have been eager to maximize the benefits from FDI and minimize harmful side effects. Restrictive economic policies have reduced the benefits and increased the costs of FDI through deadweight costs of regulation, economic costs of protection, inefficient project structures, encouragement of the use of transfer pricing to repatriate profits, and fiscal losses from tax incentives. Recently, countries that have liberalized have benefited more from FDI. This process is expected to be sustained without major reversals, as more and more countries see the benefits of more liberal policies toward FDI.

Global integration will continue to drive FDI flows, wherever the economic environment is open to it. Globalization will increasingly blur the distinction between foreign and domestically owned enterprises, and between developed and developing countries. Countries that are open to foreign investment stand to share in the rising global prosperity that globalization brings.

Nevertheless, to create an enabling environment for FDI, a large unfinished agenda of policy reform remains. Some of the countries that have made progress in reducing restrictions, including some already receiving large amounts of FDI, still have some way to go toward providing a fully open environment for FDI. Many more countries have only begun to reexamine their policies toward FDI or the impact of their general economic policies on FDI flows. Yet these countries have not missed their chance to participate in global FDI flows. The rapid increase in FDI volumes in recent years has shown that this is not a zero sum game. As more countries open up to FDI, global integration will increase, leading to an increase in overall FDI flows. The challenge for the future is therefore to open more economies and sectors to foreign direct investment, thereby bringing opportunities for economic development to a larger part of the developing world.

This report is one of a set of publications on private sector development that IFC is releasing in its Lessons of Experience series.