Attracting foreign direct investments: challenges and opportunities for smaller host economies.

Ruane, Maria Claret M.

INTRODUCTION

The Asian financial crisis of 1997 reminded many in the international community that foreign capital inflows come in different forms and that some of these forms are more desirable than or preferred over other forms. From the perspective of a recipient or host country, these different forms of foreign capital inflows have different impact on its economic development.

With several episodes of foreign debt crises by a single country or a group of countries from which to draw, the lesson has been clear that successful use of foreign loans required skillful management of the resulting debt on the part of the borrowing country. This success increases with the share of foreign loans that actually finances investment, the productivity of that investment, and the ability of the borrowing country to generate the currency in which foreign loans are to be serviced.

Foreign portfolio capital inflows are usually short-term in orientation and evidently too mobile that they can and do easily and quickly flee from a recipient country at the first sign of trouble. From past experiences, we have seen how such sudden movement in this type of foreign capital had devastating effects on countries from which they were fleeing and challenged policymakers to search for measures to minimize such effects.

The lesson is clear and the verdict is out: comparatively speaking, foreign direct investments (FDIs, henceforth) are the preferred form of foreign capital inflows. Nunnenkamp (2001) noted that FDIs are superior to other types of capital inflows because of their longer-term orientation and hence their stability, their higher likelihood of being used productively, their risk-sharing properties, and their greater likelihood of increasing the level of aggregate investment and economic development in the host country. In addition, he noted that "FDI is more than just capital as it offers access to internationally available technology and management know how", which can potentially spill over to domestic firms and result in higher productivity (quote taken from Nunnenkamp (2001), page 3).

Consequently, countries seek out this preferred form of foreign capital, FDI, thus competing fiercely against each other. This competition is further intensified by the continued globalization of markets which makes foreign capital in general and FDIs in particular even more mobile. Such mobility gives foreign direct investors, mostly multinational corporations (MNCs, henceforth), bargaining power over prospective host country governments as they choose their investment location.

At the same time, globalization has limited the policy options available to host country governments by which they could attract FDIs (Blomstrom and Kokko (2008)). For instance, the liberalization of trade in goods and services in many countries has limited national government's use of trade policy to attract FDIs. In the past, import restrictions led to FDIs that were "tariff-jumping" (Palmade and Anayiotas (2004)). These are investments that are export-oriented but are better able to access the domestic market by locating there in order to avoid the costlier import restrictions, including prohibitive tariffs. Globalization has reduced these trade restrictions and favored a movement toward more open trade and away from use of trade policies, including those that resulted in higher FDIs.

Globalization has meant liberalization of product markets as above noted but also of capital markets. As a result, host country governments that previously used exchange rate policies to attract FDIs now face pressure to limit their foreign exchange intervention and to adopt a more market-determined exchange rate system. Adding to this is the fact that the continued development of markets for financial derivatives has also equipped MNCs with many ways to reduce exchange rate risks associated with undertaking FDIs, thus diminishing the importance of exchange rate, and exchange rate policies, as a determinant of their locational decision regarding their FDIs.

With both trade and exchange rate policies of limited use to many host country governments, they needed to make greater use of those policy measures that they can control in order to attract FDIs. All of these combine to explain the proliferation of FDI incentives, and the greater competition among host country governments have made these incentives increasingly generous over time. Morisset and Pirnia (2001) note that "fiscal incentives have become a global phenomenon" (page 71), having grown since the early 1990s.

It is in this environment that many countries and their governments have to operate and find a balance between the challenges they face and the opportunities that are available to them in their pursuit of FDIs.

The paper is organized as follows. The next section will present a selective review of literature on FDIs and host country policies, with particular focus on FDI incentives and on studies published after the 1997 Asian crisis. This will be followed by a discussion of the challenges and opportunities for small host countries and their governments. Summary and concluding comments will be made in the final section of the paper.

REVIEW OF FDI AND RELATED LITERATURE

The review of the literature presented in this section is selective, rather than comprehensive, as it focuses on studies undertaken after the 1997 Asian crisis and on two specific issues: Do FDIs benefit host countries, if so, in what way? What factors are most effective in attracting FDIs into a host country?

Several studies answer this question in the affirmative. Blomstrom and Kokko (2008) point to benefits generated by FDIs in the form of higher employment, exports, tax revenue, bring knowledge and technology that will spillover to domestic firms, thus promoting economic growth. Miyamoto (2003) focuses on the interaction between human resource development and FDIs and how the former contributes to the host country's economic growth directly and also indirectly through its complementary effect on FDIs. Still others attribute the positive impact of FDI on the host country's economic growth through the increase in overall productivity as well as on domestic firm's productivity. Palmade and Anayiotas (2004) state that "in almost all cases, FDI had a largely positive impact on productivity" (page 4). Two channels by which FDIs lead to higher host country productivity have been clearly identified in the literature: the competition channel and the knowledge and technology spillover channel. As Blomstrom and Kokko (2001) point out, the increased competition brought on by FDIs have made domestic firms more productive.

The theoretical basis for the second channel is clear: FDIs bring with them knowledge and technology that spill over to domestic firms through FDIs interaction with domestic firms, through domestic firms imitating FDIs and through domestic firms hiring workers trained by FDIs. However, the evidence on the presence of knowledge and technology spillovers is mixed. This finding is important in that the most compelling theoretical justification for host country government's use of FDI incentives rest on the assumption of an externality, in this case, the spillover of knowledge and technology from FDIs to domestic firms. Of course, FDI incentives can and do exist independently of a theoretical basis. In fact, many host country governments justify FDI incentives on other grounds (for example, to increase the level of aggregate investment or to create domestic jobs (Haaparanta (1996) cited in Blomstrom and Kokko (2008)).

Morisset and Pirnia (2001) suggest that spillovers, if they exist, can have a greater impact on the host country's economy

* The greater the degree of linkage (including competition) between foreign MNCs and domestic firms

* The greater the orientation of MNCs to the local market

* The higher the level of host country's competence, including the technological capacity and learning and R&D efforts of domestic firms to absorb spilled knowledge, human capital

Having established that FDIs contribute positively to host country's economy and hence are desirable and often sought after by host countries, we then ask the question of what factors are most effective in attracting FDIs? What are the major determinants of FDIs? Might these factors or determinants include FDI incentives, and thus, more to the point, are FDI incentives effective in attracting FDIs?

Many studies (Morisset and Pirnia (2001), Nunnenkamp (2001), Miyamoto (2003)) point to economic fundamentals and political stability as the primary determinants of FDIs, with FDI incentives being a consideration only at the margin. The most effective way to express this is to say that FDI incentives, especially tax exemptions, are "like a dessert; it is good to have, but it does not help very much if the meal is not there" (Morisset and Pirnia (2001), page 76).

Morisset and Pirnia (2001) conclude that "incentives will generally neither make up for serious deficiencies in the investment environment nor generate the desired externalities... most serious investors are often unaware of the full range of incentives on offer when they invest" (page 97).

Nunnenkamp (2001) remarks that "policymakers should be aware that various measures intended to induce FDI ... are unlikely to do the trick ... Fiscal and financial incentives offered to foreign investors may do more harm than good by giving rise to costly "bidding wars"" (page 1).

Miyamoto (2003) notes that using FDI incentives to attract high value-added FDIs might work in the short-run but offers the caveat that "high value-added FDIs are not attracted solely by tax incentives" (page 40).

Morisset and Pirnia (2001) clarify the above conclusion by saying that "it is not true that tax policy and incentives fail to attract investors; they do affect the decisions of some investors some of the time" (page 81).

Figure 1 by the UNCTAD and presented by Nunnenkamp (2001, page 10) shows that importance of overall policy framework (including the often-cited economic and political stability) and business facilitation for any type of FDI (including FDI incentives). These are supplemented by more determinants that are specific to the type of FDI.

The above figure clearly shows that FDI incentives, which appear under Business Facilitation, by themselves will not attract FDIs but can work when complemented with other factors. Nunnenkamp (2001) notes that the shift toward efficiency-seeking FDIs requires that "FDI incentives focus on cost differences between locations, quality of infrastructure and business-related services, the ease of doing business, and availability of skills." Morisset and Pirnia (2001) point to importance of "long-run strategies of improving human and physical infrastructure and, where necessary, streamlining government policies and procedures, thereby increasing the chances of attracting investment on a genuine long-term basis" (page 97)"

It is also important to remember that FDI decisions are a two-stage decision: MNCs identify the region or a short list of potential host countries (stage 1), then choose one or a few from this list (stage 2). FDI incentives are found not to be significant at stage 1 but can affect final locational choice at stage 2. Morisset and Pirnia (2001) cite Forsyth (1972) who said that once other factors led to the decision, then locational decision may be strongly affected by FDI incentives. Nunnenkamp (2001) also pointed to the two-stage process of FDI decision: "after the location is broadly determined and potential candidates within a region are short-listed according to economic fundamentals, the final site selection may be influenced by fiscal and financial incentives."

There are also suggestions in the literature of a shift toward the belief that FDI incentives play a more important role in influencing FDI location decisions. Blomstrom and Kokko (2008) found support for this in more recent MNCs executives surveys and in econometric studies (Taylor (2000), cited in Blomstrom and Kokko). Palmade and Anayiotas (2004) suggest convergence of macroeconomic fundamentals and greater importance of microeconomic conditions, including FDI incentives available to certain sectors.

Although the literature does not give a definitive answer in regards to the effectiveness of FDI incentives in attracting FDIs into host countries, it is useful in prescribing how to increase the effectiveness of FDI incentives. For instance, Morisset and Pirnia (2001) find that FDI incentives are more effective in affecting the FDI decisions of the following:

* export-oriented firms because they operate in more competitive markets and are also more mobile and hence more tax-sensitive

* new firms, especially if FDI incentives can help reduce initial expenses

* small investors who, unlike large investors, are less able to develop sophisticated tax avoidance strategy or negotiate special tax treatments from host country (Coyne (1994), cited in Morisset and Pirnia (2001)

* FDIs that are financed by retained earnings than those financed external funds (debt or equity)

* firms operating in multiple markets that can take advantage of opportunity to cross-subsidize or transfer-price

CHALLENGES AND OPPORTUNITIES FOR SMALLER HOST ECONOMIES

This section draws from the literature review in the preceding section to identify the challenges and opportunities for smaller host economies and their governments as they aim to attract FDIs as a means to achieve short-term and long-term economic goals. The literature points to very few success stories of small economies: Ireland (Morisset and Pirnia (2001), Blomstrom and Kokko (2008)), Sweden (Blomstrom and Kokko (2008)), Singapore (Morisset and Pirnia (2001), Miyamoto (2003)), Costa Rica (Miyamoto (2003)).

Challenges

Host country governments in general, and those of smaller economies, in particular, face many challenges. A number of them have already been mentioned in earlier sections, including the tough competition they face from other host countries, small and large, partly because FDIs are highly mobile and MNCs can choose among a wide range of locations, each with its own economic and political characteristics and many with a varying degree of government-offered incentives.

Faced with tough competition from other host countries, a government would like to offer the most generous FDI incentives but is limited by fiscal and political constraints. Fiscal constraints are greater for smaller economies as government resources are limited with many competing demands, a tax system that is usually less developed or sophisticated, an economic structure that is not as diversified, and political factors that are more important in affecting aggregate investment in developing countries than in advanced economies (Pindyck and Solimano (1993)).

Public support for FDI incentives improves with the ability to provide evidence that such FDI incentives are effective in attracting FDIs, on the assumption that FDIs assist in achieving the host country's economic goals. The challenge becomes how well and accurately the benefits and costs associated with FDI incentives can be calculated. As Blomstrom and Kokko (2008) note, the implicit assumption has been that knowledge and technology spillovers (external benefits) are sufficiently large relative to the cost of FDI incentives (page 9). The more difficult issue to address is one put forth by Morisset and Pirnia (2001): "whether the new foreign investment would have come to the country if no or lower incentives were offered", if so, then there is no net benefit to the host country (page 93).

One of the biggest challenges faced by host country governments is how to show, not assume, that FDIs contribute positively to the host country's economic development. As noted in the previous section, the literature provides a more definitive answer that FDIs contribute positively to the host country's economy than in explaining how this positive impact comes about. The difficulty comes from showing evidence of the benefits enjoyed by domestic firms and the host country's economy in the form of knowledge and technology that spill over from FDIs and in turn increase productivity. It is much easier to show, through a multiplier model, for example, that FDIs enhance the host country's employment, tax revenues, exports and technological and knowledge levels.

Another challenge for host countries is to make it further in the location decision process by MNCs. As noted by Nunnenkamp (2001) and Morisset and Pirnia (2001), MNCs employ a twostage process in deciding on FDI: they identify the region or a short list of potential host countries (stage 1), then choose one or a few from this list (stage 2). Obviously, to get to stage 2, host countries must make it to stage 1. This suggests that there are benefits from host countries within a region to work together to make the region sufficiently attractive to FDIs so as to make it to stage 1, after which host country governments compete fiercely by offering FDI incentives in the hopes of being the location chosen by FDIs they want to attract.

Opportunities

This is not to say that attempts to address these challenges are not without rewards. On the contrary, the ability of host country governments to effectively respond to the above challenges increases their success in pursuing opportunities that are present and available to them. Post-2003 trends in FDIs bring good news to many developing countries, including smaller economies.

FDIs, which declined after 1999, have been on the rise since 2003 (Kearney (2007)). This means that, although many host countries compete to attract FDIs, there has also been an increase in the amount of FDIs for which to compete. In short, although the demand for FDIs by host countries has increased, the supply of FDIs has also increased so that there is potential for each host country to see an increase in FDI inflows in absolute terms, although not necessarily in relative terms. Using the terminology of Nunnenkamp (2001), the situation need not lead to "FDI-diversion" but instead there is opportunity for "FDI-creation" (these terminologies are parallels of "trade-diversion" and "trade-creation".)

Another good news for developing countries that are prospective hosts to FDIs, many of which are smaller economies, is an evidence of a shift in FDI inflows in favor of developing countries (Nunnenkamp (2001)). This is in marked contrast to the former preference toward developed host countries. This gets even better by noting the increase in FDI inflows to developing countries originating from other developing countries, sometimes described as "South-South FDI". As Palmade and Anayiotas (2004) note, this type of FDI is beneficial because "these new players tend to be better equipped to invest in difficult and remote markets and to develop products and services better adapted to developing country consumers." All of these developments increase the likelihood of smaller host economies in attracting FDIs.

Several authors (Nunnenkamp (2001), Miyamoto (2003), Blomstrom and Kokko (2008)) noted that globalization has diminished the importance of the size of the domestic market in MNC's locational choice for FDIs. In the past, MNCs chose to locate in countries with large domestic markets, with the intention of producing for this market. FDIs with this motivation are referred to in the literature as "market-seeking FDIs". As markets become more integrated at a regional or global level and with trade and capital markets being liberalized, the size of the market is no longer restricted to the domestic market, and MNCs have paid less attention to this factor in regards to their FDI decisions. Consequently, the motivation for FDIs have shifted from "market-seeking" to "efficiency-seeking", "motivated by creating new sources of competitiveness for firms and strengthening existing ones" (Nunnenkamp (2001)). Again, this is favorable development for smaller economies, especially those that are highly integrated with the global economy, as they now have as good a chance of being selected as FDI destination as larger economies.

Palmade and Anayiotas (2004) see an opportunity for host countries to attract FDIs into the service sector. They identify the following factors as being attractive to these types of FDIs:

* stable and smart regulatory environment for quasi-natural monopolies

* functioning land markets for retail, hotels and construction

* "protection" from unfair competition from tax-evading, low-productivity informal players

In a survey of MNC executives in several countries and across different economic sectors, Kearney (2007) found that Asian and European investors prefer to invest within their own regions. This presents opportunities for attracting FDIs for developing countries within Asia, in particular. According to Nunnenkamp (2001), small developing economies should open up early to FDI inflows and increase its integration into world trade in order to enhance FDI's positive contribution to economic growth.

SUMMARY AND CONCLUSION

It is an opportune time for many host countries, including smaller economies, to attract FDIs and make them instrumental in their pursuit for economic development and the improvement in the welfare of their citizens. As noted in the beginning of the paper, one policy instrument continues to be in their government's control, FDI incentives. Despite strong skepticism in their effectiveness in the past, there is now a rich literature from which to draw lessons on how to make FDI incentives more effective. These lessons are outlined here in brief and are a starting point in creating a guideline for the design of FDI policies in host countries:

FDI incentives must be based on rules, not discretion, thus making them more broad and general, usually a part of a more comprehensive economic development strategy, as opposed to being specific and selective (Blomstrom and Kokko (2008), Palmade and Anayiotas (2004), Nunnenkamp (2001), Morisset and Pirnia (2001). This means that FDIs incentives will be available to all economic sectors and to all firms, domestic and foreign. On a more operational level, this suggests that the host country government's decision to grant FDI incentives to any prospective recipient must be based on clearly defined criteria that are applied in an objective, a consistent and a systematic manner as opposed to being subjective, haphazard and arbitrary.

FDI incentives must be complemented by favorable overall policy framework that focus on economic and political stability, provide physical, human and institutional infrastructure and reduce the cost of doing business in the host country (Blomstrom and Kokko (2008), Morisset and Pirnia (2001). It is this more conducive business environment that addresses the first stage of MNC's decision making, without which the second stage will not be reached, the stage when FDI incentives appear to have a greater effect.

FDI incentives must be complemented by measures to create and enhance local competence, especially in ways that will allow the domestic labor force to absorb the knowledge and technology brought by FDIs (Blomstrom and Kokko (2008), Miyamoto (2003). This way, the spillover and productivity effects of FDI that are so widely discussed in the literature can be enhanced.

FDI incentives must aim to create a virtuous cycle brought about by the complementary relation between human resource development and high value-added FDIs. This recommendation highlights the point that some FDIs are more desirable than others and some level of "FDI targeting" might be desirable. Note that such targeting is not inconsistent with the earlier proposed use of general instead of selective policy. To this end, Miyamoto (2003) suggests that "governments that emphasize flexible demand-driven human resource development strategies, target MNCs in high value-added areas, and coordinate education and training policies are more likely to lead the country into a virtuous circle" (page 42).

Similarly, some FDIs are more responsive to incentives than others. Therefore, host country governments must find a way to redesign their FDI incentives program so that it targets those FDIs that are likely to be more responsive to the FDI incentives being offered. By doing so, the effectiveness of their FDI program can be enhanced.

According to Morriset and Pirnia (2001), the following types of FDIs are more likely to respond to host country incentives:

1. export oriented because they operate in more competitive markets and are also more mobile

2. small investors rather that do not have sophisticated tax avoidance strategies that large investors have

3. FDIs that operate in multiple markets as they have the opportunity to use strategies such as cross-subsidization and transfer-pricing in order to maximize their overall profits

REFERENCES

Ajaga, Elias & Peter Nunnenkamp (2008). Inward FDI, value added and employment in US states: a panel cointegration. Kiel Institute for the World Economic Working Paper 1420, May.

Banks, David (2001). Best practice guidelines for investment promotion. Proceedings for the OECD-China Conference on Foreign Investment in China's Regional Development: Prospects and Policy Challenges.

Bitzer, Jurgen & Holger Gorg (2008). Foreign direct investment, competition and industry performance. Kiel Institute for the World Economic Working Paper 1416, April.

Blomstrom, Magnus & Ari Kokko (2008). The economics of foreign direct investment incentives. Kiel Institute for the World Economic Working Paper 168, January.

Kearney, A. T. (2007). FDI Confidence Index 2007. Retrieved on June 27, 2008, from http://www.atkearney.com/shared_res/pdf/45130A_FDICI_2007.pdf

Miyamoto, Koji (2003). Human capital formation and foreign direct investment in developing countries. Organisation for Economic Co-operation and Development (2003). OECD Development Centre Working Paper 211, July.

Morisset, Jacques & Neda Pirnia (2001). How tax policy and incentives affect foreign direct investment: a review. In Using Tax Incentives to Compete for Foreign Investments: Are They Work the Cost. Foreign Investment Advisory Service Occasional Paper 15.

Nunnenkamp, Peter (2001). Foreign direct investment in developing countries: what policymakers should not do and what economists don't know. Kiel Institute for the World Economic Discussion Paper 380, July.

Organisation for Economic Co-operation and Development (2003). Checklist for direct foreign investment policies. Paris, France: OECD.

Palmade, Vincent & Andrea Anayiotas (2004). FDI trends. Public Policy for the Private Sector 273, September.

Pindyck, Robert S. and Andres Solimano (1993), "Economic Instability and Aggregate Investment" NBER Macroeconomic Annual, 8, 259-303.

United Nations Conference on Trade and Development (2000). Tax incentives and foreign direct investment: a global survey. New York, U.S.A. and Geneva, Switzerland: United Nations.

Maria Claret M. Ruane, University of Guam

Figure 1: Selected Host Country Determinants of FDI

Overall Policy Framework

[right arrow] economic and political stability
[right arrow] rules regarding entry and operations of TNCs
[right arrow] bi- and multilateral agreements on FDI
[right arrow] privatization policy

Business Facilitation

[right arrow] administrative procedures
[right arrow] FDI promotion (e.g. facilitation services)
[right arrow] FDI incentives (subsidies)Economic Determinants'

1. Relating to resource-seeking FDI
[right arrow] raw materials
[right arrow] complementary factors of
 production (labor)
[right arrow] physical infrastructure

2. Relating to market-seeking FDI
[right arrow] market size
[right arrow] market growth

[right arrow] regional integration

3. Relating to efficiency-seeking FDI
[right arrow] productivity-adjusted labor costs
[right arrow] sufficiently skilled labor
[right arrow] business-related services
[right arrow] trade policy

(a) Differentiated by major motivations of FDI.

Source: Adapted from UNCTAD (var. issues 1998: Table IV. 1).