30395 ul z z 0 °- VI sW 0 0 r4 c FDI Trends v La l'iii,(eiit ,clnanlaiid Looking Beyond the Current Gloom in Developing Countries .4 ,ndrea tna yiatas The fall in foreign direct investment (FDI) since 1999, and China's growing share, worry most developing countries. But an in-depth look | | . ) z~~s a lead economniAt at the reveals new and promising trends. The decline is largely a one-time areign, Issnestment adjustment following the privatization boom of the 1 990s. FDI is A dV'i7.initT Servlice (FlJAt,s a joaint Piilit oj Ithe coming from more countries-and going to more sectors. The lVon-ld Bank and conditions for attracting FDI vary by sector: in labor-intensive _ Inten atiorna l Fin ') nancre Capotatin. Andrea manufacturing, for example, efficient customs and flexible labor Aitm-i'mas is a coam iin, lta markets are key, while in retail access to land and equal enforcement ' w7ilh 1/.tS. Tl2i.s NTote is wit FIS. his7\ae ~ of tax rules matter most. Sorting out the microeconomic issues by o> ]unded in p(irt In FIAS, 0hi(h htle/ goiiverinmeiis sector will be good not only for FDI but also for domestic investors. nI. rm ve thei)r conntir s busine.ss eiiv'iroanment to eii( )(iiira' ki)ei,rr dir-et The flows of foreign direct investment (FDI) to remained low. Eastern European countries are rn(ourage deeloingcontresnavedecine b iiiusmtmnt -developing countries have declined bv 26 per- counting on integration with the European cent since 1999, while China's share has Union to help renew FDI flows. increased from 21 percent to 39 percent (figure 1). The large flows of FDI to banks and utilities Reasons for hope dwindled following a series of disappointments But a more in-depth look suggests a more com- O for both investors and governments. China now plex andl hopeful storv. Despite the decline in has a commanding lead in manufacturing, with FDI since 1999. its growth over the past 13 years a large, qualified, low-cost, and flexible work- has been phenomenal, averaging more than 17 z force. India seems to be following suit in the percent annually in dollar terms. The decline co promising ofshore services sector. since 1999 is due mostly to the drop in FDI fol- As a result of all this, manNy developing coun- lowing the boom in huge (one-time) privatiza- tries regard their prospects for FDI as bleak. tion deals in the infrastructure, financial, and O The gloom is particularly strong among Latin petroleum sectors in the 1990s. FDI in other sec- American and Southeast Asian cotuntries, once tors remained fairlv constant (figure 2). This JW the darlings of foreign investors. FDI levels in cyclical effect is confirmed bv the much starker Africa, the Middle East, and South Asia have "rise and fall" pattern in FDI flows to industrial FDI TRENDS LOOKING BEYOND THE CURRENT GLOOM IN DEVELOPING COUNTRIES to excessive returns. The financial and infra- structure sectors are tricky to regulate as quasi- US$ billions natural monopolies, but FDI is not to blame for 200 government shortcomings. I50 ~ In sectors where competition is stronger, FDI All other has had a much more obvious positive impact. A 100 developing study of India by the McKinsey Global Institute countries (2001) showed that the removal of FDI restric- 50 tions in the automotive sector unleashed com- 2 China 0 petition and investments, resulting in a 1990 1992 1994 1996 1998 2000 2003a threefold increase in productivity that trans- a. Estimated. lated into a threefold increase in output due to Source World Bank 2004. falling prices (figure 3). Employment also rose. So, once adjusted for the one-time events and countries over the same period. Another (hope- government shortcomings. the fundamental fully one-time) factor driving the decline has picture of FDI is quite positive. been the macroeconomic crisis and uncertain- ties affecting Latin America. China in perspective China's commanding FDI performance also Positive impact on development should be put into perspective. While China While many observers believe that much of the accounts for 39 percent of the FDI to develop- FDI in the financial and infrastructure sectors ing countries, it also accounts for almost 30 per- yielded little impact, this perception does not cent of the developing world's population. In stand up to in-depth analyses such as those by fact, relative to GDP, China's performance in Luis Guasch (2002), Clive Harris (2003), and attracting FDI is good but not extraordinary, the McKinsev Global Institute (2003). These with FDI at 3.8 percent of GDP in 1999-2002. studies have shown that in almost all cases FDI Nineteen developing countries did better over had a largely positive impact on productivity the same period. China's performance looks (the key criterion for assessing long-term eco- even less extraordinary if adjusted for the nomic performance) and on1 the coverage of round-tripping of FDI through Hong Kong services. But ill-designed privatization processes, (China), which some estimates suggest may contracts, and regulations have often led to account for as much as 30 percent of total FDI poor returns on investments or, in some cases, to China. * Foreign direct investment flows to 20 New diversity in sources and destinations largest developing country recipients Another reason for hope is that the sources of by sector, 1998-2002 FDI are increasingly varied. "South-south" FDI C) 1U$ billions flows are expanding rapidly; they now account 2 200 for more than 30 percent of FDI to developing 150 countries, up from 17 percent in 1995. China and South Africa are becoming major players in 100 Infrastructure, financial, and petroleum sectors Africa, for example, with about US$2.7 billion and US$1.6 billion of FDI there by 2001, the lat- so Other sectors est year for which statistics are available. That developing countries are growing 1998 1999 2000 2001 2002 sources of FDI is doubly good news because these new players tend to be better equipped to Sturce: Economic tommission for Latin America and the Caribbean, Association of Southeast Asian Nations, United Nations Conference on Trade and Development, invest in difficult and remote markets and to and goverrnment statistics.develop products and services better adapted to 05-0-Momi 3:2 Barriers Labor productivity Output Employment | ' ) ~~~~~~Barriers K 3removed Licensing 356 380 abolished FDI allowed 100 100 100 1 1 Il 3 1992-93 1999-2000 1992-93 1999-2000 1992-93 1999-2000 Source: McKinsey Global Instilute t00 1. developing country consumers. The Turkish Implications for governments conglomerate Koc was the first company to So there is no reason for developing countries open hypermarkets in the Russian Federation- to despair. But in an increasingly competitive with great success. Chinese electronics produc- market, getting their fair share of FDI flows and ers such as TCL know how to prodtoce US$50 benefits will be hard work. Attracting FDI will color televisions in India and Vietnam. while require a shift in mind-set for most developing Marsoti Suzuki in India is ready to export cars for country governments. US$2,000. These are low-spec products, but thev are exactly what consumers in developing coun- Broadening the scope of FDI tries need, as they often face the unhappy choice To start with, the scope of efforts to attract FDI between high-spec buot unaffordable "Western" must encompass all economic sectors. The ten- products and very, low-spec but relatively expen- dency in the past was to focus almost exclusively sive traditional products. on infrastructure and on efficiency-seeking and Yet another reason to be hopeftil is that the tariff-jumping FDI in manufacturing. In the destination sectors of FDI also are becoming fuiture more and more FDI will be market- more varied. FDI has evolved from focusing pri- seeking investment in service sectors as well as marily on natural resources, infrastructure, and investment in tourism and offshore services. manufacturinig (export-driven or "tariff jump- Most developing countries continue to restrict ing" investment) to also covering banking, retail, FDI in service sectors (for example, India does construction, tourism, and offshore services. not allow FDI in retail), yet are ready to waste for- Cumiolative FDI flows to the retail trade sector in tunes to attract efficiency-seeking FI)I for manu- the 20 largest developing countries amounted to facturing in an uphill battle against China. US$45 billion in 1998-2002 (about 7 percent of There is a general misconception that the total to these countries). That too is good market-seeking FDI in domnestic sectors such as news, since more and more couontries can hope retail yields little development impact. The to develop comparative advantages in a few of opposite is true. FDI in retail has been a key these new sectors. Moreover, FDI is increasingly driver of productivity growth in Brazil, Poland, market seeking rather than efficiency seeking and Thailand, resulting in lower prices and (that is, export driven), offering opportunities to higher consumptioni. Large-scale foreign retail- any country willing to open its markets or inte- ers are also forcing wholesalers and food proces- grate with its neighbors. soIs to improve. And they are now becoming These encouraginig FDI trends in the devel- important sources of exports: Tesco in Thailand oping world should be expected to continue, and Wal-Mart in Brazil are increasingly ttirning since they mirror what has happened in the to local products to feed their global supply industrial world. chains. Retail also happens to be a pillar of the FDI TRENDS LOOKING BEYOND THE CURRENT GLOOM IN DEVELOPING COUNTRIES tourism industry. The misconceptions about FDI Note are made worse by political economy factors: 1.Theimportanceofmicroeconiomicbarrierstogrowth while attracting efficiency-seeking FDI does not has been documented in great detail by the WUorld Bank's affect incumbents, attracting market-seeking Investment Climate Assessments (http:/','wwAw.world FDI usuallv does. bank.org/pivatesector/ic,/index.htm) and DoingBusiness viewpJoint studies (http:,/,/rru.worldbank.org/'Doing Business/) as Tackling microeconomic issues well as bv the McKinsev Global Iistittite's industrv-le'el In addition to broadening the scope of efforts, analvsis (http:/0//wwsvw.mckinsey.com,/ I. ' .1 'mgi/). is an open forumn to countries must recognize that the battle for FDI encourage dissemination of will increasingly be fought at the microeconomic References public policy innovations for level sector by sector. Of course, foreign Guasch, Luis. 2002. "The Experience of Latin America private sector-led and investors will continue to insist on basic political ivith Performanice-Based Contracts." World Banik, Iatin market-based solutions for and macroeconomic stability, but this should America and the Caribbean Region, Finance, Pr-ivate development. The views become less important as a differentiating factor. Sector, and Infrastructure UInit, ' \ i. ........... D.C. published are those of the Investors will look increasingly at micro- Harris, Clive. 2003. Private Participation in lnfrastnictore authors and should not be economic conditions, and what they look for will in Dezelopinig Countrie,s: Trends, Impacts, and PoliM Lesson.s. attributed to the World varv signiificantly from one sector to aniother. World Bank Working Paper5. A 5 1 ......I l D.C. Bank or any other affiliated The requirements for efficiency-seeking McKinsev Global Institite. 2001. Indias Grozwth organizations. Nor do any of investment in manufacturing are increasingly Impentzive. Mumbai. the conclusions represent well understood-low factor costs, a flexible - . 2003. Verv Horizons. San Francisco. official policy of the World labor market, a small regulatory burden, effi- World Bank. 2004. Global Development Finanice 2004: Bank or of its Executive cient infrastructure and customs. Less obvious Horn cussiig Cyclical (;ainsforDezvelopmeot.W ii ,u '., D.C. Directors or the countries factors include easy access to a competitive sup- FOREIGN they represent. plier base and business service providers. INVESTMENT The factors required to attract FDI in domes- =_ ADVISORY To order additional copies tic services are vastly different-a stable and _ SERVICE contact Suzanne Smith, smart regulatory environment for quasi-natural managing editor, monopolies (a hard-won lesson from the Room 19-009, 1990s). functioning land markets for retail, The World Bank, hotels, and construction. In addition, unfair 1818 H Street, NW, competition from tax-evading, low-productivity Washington, DC 20433. informal players has been found to be among Telephone: the biggest constraints to FDI growth in domes- oo 202 458 7281 tic services in most developing countries, and it Fax: tends to get worse over time.I 001 202 522 3480 Resolving the microeconomic issues sector Email: by sector will be good for FDI as well as for ssmith7@worldbank.org domestic private investors-and thus key to boosting growth and reducing poverty. But most Produced by Grammarians, developing countries have a long way to go. Inc. Printed on recycled paper "Kim,l-lywon cha" This Note is available online: http:llrru.worldbank.orglPublicPolicyjournal