October 30, 2006	Monday	Shawwal 6, 1427

Foreign direct investment (FDI) is investment in new or existing facilities involving control of a foreign enterprise. As against volatility of foreign portfolio investment in stocks and shares, FDI involves a long-term commitment, and is seen as the most important source of foreign financing.

Investment creates jobs and expands output. For developing countries, FDI is necessary to fill the gap between domestic savings and the desired level of investment. On the other hand, for foreign investors—transnational corporations (TNCs)—the investment oversees serves in the main four purposes: One, it enables them earn far more profits than it would be possible otherwise.

Two, it enables them to locate their manufacturing activities where they can be performed most efficiently or cost effectively. Three, it enables them to re-introduce a product in a foreign market, often by customising it with the foreign country environment, after the product has reached the maturity stage in the domestic market. Four, it enables them to diversify their portfolio and thus minimise risks

The decision to invest in a foreign country, like other business decisions, is based on cost and benefit analysis. Speaking generally, FDI is made in a country, if perceived benefits outweigh perceived costs.

As a principle, FDI is made in those countries where risks are low and returns are high. However, speaking in specific terms, there are many factors in the host country which restrict or promote FDI.

Before we discuss these factors, let’s look at global FDI inflows.

In 2004 were $648 billion. Of these, developed countries attracted FDI worth $380 billion, while developing countries attracted FDI worth $233 billion. This gives developed and developing countries shares of 59 and 36 per cent respectively.

The USA, which attracted FDI worth $96 billion, was the single largest beneficiary of FDI inflows. The USA was followed by China, which attracted FDI inflows worth $64 billion. Hong Kong, a special administrative region of China but a separate customs territory, attracted FDI worth $34 billion.

If we add FDI inflows into Hong Kong to FDI inflows into mainland China, China becomes the largest beneficiary of FDI inflows—a total of $98 billion. Region wise, the European Union (EU 15), received the largest amount of FDI whose value was $197 billion.

Conversely, the entire continent of Africa could attract only $18 billion worth FDI. The least developed countries (LDCs), the economies most in need of FDI inflows, received FDI inflows of only $11 billion.

The main factors which promote or restrict FDI inflows include the level of demand in the host country, the absence or presence of created assets, protection of FDI, the overall investment climate, the economic environment, and the political situation. We begin with the level of demand. The level of demand in the host country depends in the main on two factors: the purchasing power of the consumer, and the size of the market.

Consumer purchasing power is measured by income. Ceteris paribus, countries with higher per capita income are more attractive markets for foreign investment than countries with low per capita income. One reason for low level of FDI in LDCs and most developing countries is low per capita income. This is a catch 22 situation for these countries.

In these countries, the level of domestic investment is low mainly because domestic savings are low and domestic savings are low, because per capita income is small. These countries need FDI to bridge the gap between domestic savings and the desired level of investment caused by low per capita income. But FDI inflows into these countries are restricted, inter alia, because of small per capita income.

The second factor underlying the level of demand is the size of the market. The larger a market, the greater attraction it holds for foreign investors. This is for at least three reasons. In the first place, a large market has a high level of aggregate demand.

In the second place, a large market makes it possible for businesses to actualize the economies of scale and thus bring down the cost of production. In the third place, in a large market generally surplus labour is available which increases the marginal utility of capital. An obvious example of the relationship between market size and FDI inflows is China.

However, mere market size, though important, is not sufficient to attract FDI. A case in point is India, the second largest market after China, which received only $5 billion FDI in 2004, while Singapore, a country many times smaller than India, managed to receive $16 billion FDI in the same year. This means there are factors other than market size which must be looked into which attract TNCs. One of these factors is created assets, which refer to the existing level of human resources and commercial and physical infrastructure. While countries need FDI to upgrade their created assets, foreign investors need existing level of created assets in choosing a market for investment.

It is created assets which mainly explain why a miniscule city-state of Singapore receives three times more FDI than a giant India. Again, it is lack of created assets that is the main reason for low level of FDI in LDCs and Africa.

The third important factor is protection of investment and the related assets such as intellectual property rights. The host country must put in place a strong legal framework for the protection of investment. Such framework must guarantee to the foreign investor most favoured nation treatment (MFN), national treatment and fair compensation in case of expropriation of investment.

MFN treatment means that any advantages, privileges and immunities granted to the investors of one country are extended to the investors of other countries as well. National treatment means that the host government will not discriminate between foreign and local investors in terms of application of laws, rules and taxes.

Since at present, there is no multilateral investment treaty, countries enter into bilateral investment treaties to ensure that their investors are not discriminated against vis-à-vis other investors from other countries as well as investors from the host country and are also immune from arbitrary change in policies of the host government.

Protection of IPRs is also an important component of an effective legal regime for investment. Generally, investors are reluctant to enter into a foreign country if its laws and administrative procedures do not provide for effective protection of copyrights and patents.

But there are exceptions. China, for example, lacks an effective IPRs enforcement system but still it is the most attractive market for foreign firms. This is due to the huge size of the Chinese market and the fast pace at which the economy is growing for last more than a decade.

The investment climate includes the overall investment policies of the host government. Arguably, the most important of these policies are what are commonly referred to as trade related investment measures (TRIMS). The host government while attracting FDI has some policy objectives to achieve. For instance, they may want to encourage the development of ancillary industries, seek transfer of technology, create jobs in a particular sector or safeguard or improve the balance of payment (BoP) position.

In order that these objectives are achieved, the host government puts many conditions on the foreign investor. Such conditions are called TRIMS. The most common TRIMS are: Local content requirement, which requires that the foreign investor shall use a certain amount of local inputs in production; technology transfer requirement, which stipulates that the foreign investor shall transfer specified technology to local firms; trade balancing requirement, which requires that imports must be equivalent to a certain proportion of exports; foreign exchange restrictions, which restrict access to foreign exchange and thus access to imports.

Export requirement stipulating that a certain proportion of the output shall be exported; remittance restriction place curbs on the right of the foreign investor to repatriate returns from investment; local equity requirement, which requires that a certain proportion of assets must be owned by local persons; and employment requirement, which stipulates that a certain percentage of the workforce employed in a foreign-owned enterprise shall consist of the local people.

While the use of TRIMS may be necessary to achieve some key policy objectives, it is not without problems. In the first place, the use of TRIMS discourages foreign investors, because it deprives them of the freedom to purchase labour and capital inputs from the market where it is most suitable from them.

Moreover, as a rule, firms are reluctant to transfer technology, because technology is the strategic source of their competitive advantage. In the second place, many of the TRIMS, such as the local content requirement, are not approved of by the Agreement on Trade Related Investment Measures of the World Trade Organisation (WTO). Therefore, for both practical and legal reasons, countries should use TRIMS with caution.

The economic environment includes the state of the economy, price and productivity of inputs, availability of finance and subsidies, market-oriented policies like a floating exchange rate, privatisation, growth of the market, and proximity to other markets.Socio-political factors include political stability, law and order situation, government policies, political image of the country, continuity of policies, clean administration and fair treatment to TNCs from the host government.

A country characterised by political instability, bad law and order, poor governance, ad hocism of policies, a negative political image, corruption in high places and lack of fair treatment to foreign enterprises does not have a good potential for foreign investment, because these factors increase the risk of doing business.