foreign direct investment and development: where do we stand?

JBICI Research Paper No. 15

Foreign Direct Investment and Development:

Where Do We Stand?

June 2002

JBIC InstituteJapan Bank for International Cooperation

JBICI Research Paper No. 15Japan Bank for International Cooperation (JBIC)Published in June 2002© 2002 Japan Bank for International Cooperation

All rights reserved.

This Research Paper contains a selection of surveys and studies conducted at the JBIC Institute * for

the internal use of JBIC and for the general public. The views expressed in the articles of this ResearchPaper are those of the authors and do not necessarily represent the official position of the Japan Bank

for International Cooperation. No part of this Research Paper may be reproduced in any form without

the express permission of the publisher. For further information please contact the Planning andCoordination Division of our Institute.

* Japan Bank for International Cooperation (JBIC) was established in October 1999 as an organization

that conducts Japan’s external economic policy and economic cooperation. JBIC is pursuing a moreenhanced role by integrating the functions of two merged organizations: The Export-Import Bank ofJapan (JEXIM) and the Overseas Economic Cooperation Fund, Japan (OECF).Upon the establishment of JBIC, the JBIC Institute (JBICI) was created as its research arm. Itsresearch activities are geared toward improving the overall quality of JBIC’s operations throughsystematic analysis of various issues and policies related to JBIC’s activities. JBICI was establishedby merging the two former research institutes: the Research Institute for International Investmentand Development (RIIID) of JEXIM and the Research Institute of Development Assistance (RIDA) ofOECF.

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Foreword

Since 1993, the flow of foreign direct investment (FDI) rapidly expandedacross the world. This growth was caused by an increase in mergers andacquisitions among OECD countries as well as by policy initiatives aimed at

deepening regional integrity. As this trend gained force, policymakers in hostcountries started to ask a question: “What implications would these FDIs have onour country’s long-term economic growth?” Whereas the traditional theory had it

that “FDI could become the engine of growth for host countries through thetransfer and diffusion of knowledge”, there is now an increasing need to assessthis claim by conducting empirical studies.

This report is an elaborate analysis of the effects of direct investments ondeveloping economies. The study was the result of collaboration between the

Japan Bank for International Cooperation (JBIC) and the OECD DevelopmentCentre, led by Mr. Kiichiro Fukasaku. The Development Centre has wideknowledge and expertise of international economic and development issues. In

particular, this report makes an empirical examination of the complexinterdependence between FDI and economic growth in host countries. It alsopoints to the significance of adopting more constructive, rules-based policies

towards FDI. We hope this report will further the reflection on multilateralnegotiations on trade and investment under WTO. It was presented to aworkshop sponsored by JBIC in Tokyo in December 2001, and discussions at that

workshop are reflected in the report.

Finally, let me express my appreciation to many people from various

institutions, at home and abroad, whose great support and cooperation has madethis study possible.

June, 2002Koji FujimotoExecutive Director

JBIC Institute

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Acknowledgements

This study is the final product of a collaborative effort that began officially inAugust 2001 between the Japan Bank for International Cooperation (JBIC) inTokyo and the Organisation for Economic Co-operation and Development (OECD)

in Paris. The idea of undertaking a joint research project between the twoorganisations was first proposed by Mitsuhide Noguchi, then Director-General ofthe Research Institute for Development and Finance (hereafter referred to as the

JBIC Institute), when he visited Paris in the summer of 2000. Subsequently, theidea received official support with endorsement from Koji Fujimoto, ExecutiveDirector of the JBIC Institute. The project was jointly managed by Kaoru Hayashi,

Deputy Director-General of the JBIC Institute, and Kiichiro Fukasaku, Head ofResearch Division II at the OECD Development Centre.

The research theme selected, “FDI and Development”, is both timely and

important. The OECD Development Centre published a seminal work on thistopic nearly 30 years ago (Reuber et al., 1973). Since then, many developingcountries have significantly, and in some cases dramatically, altered their

regulations and policies towards foreign direct investment. The topic thereforemerits further investigation today, taking into account the development of newpolicy environments in host economies. It is also important that the research on

this topic be conducted jointly. The JBIC Institute has accumulated a wealth ofinformation on Japanese multinationals’ foreign affiliates located in Asia byconducting a survey every year since 1989. Owing to time constraints, however,

the collaborative effort has been confined for the present to carrying out aliterature review in several selected areas. Further research is thus warranted tocover other areas of interest for both home and host economies.

The study was primarily drafted by Kiichiro Fukasaku, with substantialcontributions from Federico Bonaglia (Chapters Ⅲ and Ⅶ), Andrea Goldstein(Chapter Ⅵ), Charles Oman (Chapter Ⅶ) and Ophélie Chevalier (Chapter Ⅶ), as

well as from the OECD Directorate for Financial, Fiscal and Enterprise Affairs(Chapters Ⅱ and Ⅴ). Technical and secretarial support was provided by Ly NaDollon, Morag Soranna and Mayrose Tucci and by Neil Beshers, external

consultant.The authors are very grateful for useful discussions with and continuous

encouragement from our colleagues, notably, Jorge Braga de Macedo, Ulrich

Hiemenz, Helmut Reisen, David O’Connor, Koji Miyamoto, Maria Maher andHans Christiansen. The first draft of the study was presented at a seminar inTokyo on 4 December 2001, eliciting helpful comments and suggestions from

Professor Shujiro Urata (Waseda University), Professor Shigeki Tejima

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(Nishogakusha University) and other seminar participants. This final version hasincorporated these invaluable contributions as much as possible within theframework of the project description agreed between the two organisations.

Finally, the opinions expressed in this work are those of the authors and donot necessarily reflect those of the Organisation to which they belong.

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Table of Contents

Foreword ････････････････････････････････････････････････････････････ⅰ

Acknowledgements････････････････････････････････････････････････････ⅱTable of Contents ･････････････････････････････････････････････････････ⅳ

List of Figures ･･･････････････････････････････････････････････････････ⅵ

List of Tables･････････････････････････････････････････････････････････ⅵList of Boxes ･････････････････････････････････････････････････････････ⅵ

List of Annex Tables･･･････････････････････････････････････････････････ⅶ

Abstract ･････････････････････････････････････････････････････････････ⅷ

Chapter Ⅰ Introduction･･･････････････････････････････････････････････1

Chapter Ⅱ Trends in FDI: Global and Regional Perspectives ･･･････････････112.1 A Global Surge in FDI since 1993 ････････････････････････15

2.2 Regional Trends･･･････････････････････････････････････19

Chapter Ⅲ The FDI-Growth Nexus ････････････････････････････････････27

3.1 Putting Theory to Work･････････････････････････････････283.2 FDI and Growth: Empirical Evidence ･････････････････････31

3.2.1 Threshold Externalities ････････････････････････････33

3.2.2 Local Financial Markets ･･･････････････････････････33

Chapter Ⅳ FDI-Trade Linkages ･･･････････････････････････････････････40

4.1 Standard Models ･･････････････････････････････････････414.2 The Substitution-Complementarity Hypothesis Revisited ････444.3 Aggregation, Causality and Endogeneity ･･････････････････45

4.4 Towards a Unified Approach ････････････････････････････48

Chapter Ⅴ FDI and Technology Transfer ･･･････････････････････････････56

5.1 Mechanisms of Technology Transfer ･･････････････････････585.1.1 Vertical Linkages with Suppliers and Buyers ･･････････585.1.2 Horizontal Linkages through Demonstration and

Competition･･････････････････････････････････････605.1.3 Labour Turnover･･････････････････････････････････625.1.4 International Technology Spillovers･･････････････････63

5.2 Technology Transfer and Host-country Conditions ･･････････65

Chapter Ⅵ FDI, Privatisation and Corporate Governance･･････････････････71

6.1 Privatisation Trends in the 1990s ････････････････････････72

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6.2 Why Is Latin America More Advanced in Privatisation? ･･････766.3 Privatisation: Brazilian Style････････････････････････････776.4 An Assessment of Privatisation Policy･････････････････････79

6.5 Implications for Corporate Governance････････････････････80

Chapter Ⅶ Host-government Policies for Attracting FDI ･･･････････････････83

7.1 Incentive-based and Rules-based Measures ････････････････837.2 Some Observations from Case Studies ････････････････････877.3 The Cost of Investment Incentives････････････････････････89

7.4 Towards Constructive Rules-based Policies ････････････････92

Chapter Ⅷ Summary and Conclusions ･････････････････････････････････110

Bibliography ････････････････････････････････････････････････････････114

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List of Figures

Figure 1.1. The Role of FDI in Development: Host-country Interests ･･･････････7

Figure 2.1. Trends in World Merchandise Exports and FDI Outflows･･････････12Figure 2.2. World Merchandise Trade and FDI Flows, 1989-2000 ･････････････15Figure 2.3. Trends in FDI Inflows, Cross-border M&As and Privatisation･･････16

Figure 6.1. Global Trends in Privatisation Revenues ･･･････････････････････73Figure 6.2. Privatisation Revenues by Major Non-OECD Region, 1990-99 ･･････74Figure 6.3. Privatisation Revenues in Non-OECD Regions by Major Sector,

1990-99････････････････････････････････････････････････････74Figure 6.4. Privatisation and FDI Inflows in Latin America･･････････････････75Figure 6.5. Privatisation and FDI Inflows in East Asia･･････････････････････76

List of Tables

Table 1.1. US Direct Investment Position in Selected Asian Economies,by Sector････････････････････････････････････････････････････5

Table 2.1. Foreign Affiliates in Manufacturing Industry of Selected OECDCountries･･･････････････････････････････････････････････････14

Table 2.2. Cross-border M&As by Region/Economy of Seller･･････････････････17

Table 2.3. Cross-border M&As as a Percentage of FDI Inflows ･･･････････････19Table 2.4. FDI Outflows by Home Region/Economy･････････････････････････20Table 2.5. World’s 20 Largest Home Economies of FDI･･････････････････････21

Table 2.6. FDI Inflows by Host Region/Economy ･･･････････････････････････22Table 2.7. World’s 20 Largest Recipient Economies of FDI･･･････････････････23Table 2.8. Net FDI Exporters and Importers ･･････････････････････････････25

Table 7.1. Foreign Investment Regime in the Host Economy: Main Types ofRegulatory and Incentive Measures ･････････････････････････････84

Table 7.2. Investment Incentives in the Automobile Industry ････････････････91

List of Boxes

Box 2.1. International Investment Instruments････････････････････････････12Box 2.2. Is China a Special Case?････････････････････････････････････････26

Box 3.1. Short-term and Long-term Impacts of FDI on Growth ･･･････････････30Box 5.1. FDI as a Mode of Technology Transfer ････････････････････････････57Box 6.1. The Power Crisis in California: What Went Wrong?･････････････････72

Box 7.1. Policy Competition for FDI: A Race to the Bottom? ･･････････････････86

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List of Annex Tables

Annex Table 3.1. FDI and Growth: Literature Survey ･･････････････････････37Annex Table 4.1. FDI-Trade Linkages: Literature Survey ･･･････････････････50Annex Table 5.1. FDI and Technology Transfer: Literature Survey ･･･････････68

Annex Table 7.1. FDI Policy Regimes in Latin America ･････････････････････96Annex Table 7.2. FDI Policy Regimes in Asia･････････････････････････････102

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Abstract

Foreign direct investment (FDI) has been one of the defining characteristicsof the world economy during the last two decades. Some developing economieshave emerged as major recipients of FDI flows in recent years, while many others

have attempted to attract such flows, often by offering fiscal and financialincentives to foreign investors. This work reviews and discusses recent empiricalstudies on key development issues related to FDI. The literature review focuses on

five main areas of interest to host economies: the FDI-growth nexus; FDI-tradelinkages; FDI and technology transfer; FDI, privatisation and corporategovernance; and host-government policies for attracting FDI.

Three of the conclusions reached in this study deserve special attention.First, a vast majority of existing empirical studies indicate that FDI does make apositive contribution to both income growth and factor productivity in host

economies. FDI tends to “crowd in” domestic investment, as the creation ofcomplementary activities outweighs the displacement of domestic competitors.Similarly, in the North-South context the relationship between FDI and trade is

more one of complementarity than of substitution, owing to backward and forwardlinkages. Second, host countries will not be able to capture the full benefitsassociated with FDI until they reach a certain threshold level in terms of

educational attainment, provision of infrastructure services, local technologicalcapabilities and the development of local financial markets. The results of recentempirical studies based on microeconomic (firm- or plant-level) data indicate that

the “spillover” effect of FDI on the productivity growth of local firms does notoccur automatically, highlighting the complex nature of interactions betweenmultinational enterprise (MNE) affiliates and local firms. Third, the role of FDI in

development goes beyond the traditional areas of growth, trade and technologytransfer to cover emerging areas of policy concern, such as mergers andacquisitions, privatisation, corporate governance and “policy competition”. Further

research along these lines is certainly warranted to meet the future challenges ofimproved regulation and policy making.

The study concludes by stressing that host-government policies should

attach greater importance to the stability and predictability of the local businessenvironment in which MNE affiliates operate. To this end, host countries shouldpursue both multilateral and regional approaches to adopting more constructive,

rules-based policies concerning FDI.

1

Chapter Ⅰ Introduction

This study takes a fresh look at key development issues related to foreigndirect investment (FDI) in developing and emerging economies in the light ofcountry experience and policy-oriented work available in this area. It draws on

existing empirical studies in the literature, including those conducted by theDevelopment Centre and other parts of the OECD. Its main purpose is to advancethe policy debate about the role of FDI in sustaining the long-term development of

host economies.

FDI has been one of the defining characteristics of the world economy over

the past 20 years. At the aggregate level, this form of private capital flows hasgrown at an unprecedented pace for two decades. Over the 1998-2000 period thetotal amount of FDI flows into developing countries exceeded official aid flows by a

factor of more than three. Along with international trade, FDI has been regardedas an engine for economic growth and for integrating developing countries into theworld economy. The potential benefits of FDI can come through several channels.

First, FDI is less volatile than other private flows and provides a stable source offinancing to meet capital needs (Lipsey, 2000; Soto, 2000; Reisen and Soto, 2001).Second, FDI is an important — and probably the dominant — channel of

international transfer of technology. Multinational enterprises (MNEs), the maindrivers of FDI, are powerful and effective vehicles for disseminating technologyfrom developed to developing countries and are often the only source of new and

innovative technologies, which are usually not available in the arm’s-length market.Third, the technology disseminated through FDI generally comes as a “package”including the capital, skills and managerial know-how needed to exploit the

technology appropriately. Finally, other potential benefits of FDI for host countriesinclude increased competition in the products market, human capital developmentand an improvement in corporate governance standards and legal frameworks.

Recent years have seen increased public concern that these benefits have yetto be demonstrated and that, where benefits exist, they may not be shared

equitably in society1. The adjustment costs associated with FDI include higher

1 The impact of FDI on the development process has been discussed at length since the late 1960s.See inter alia Reuber et al. (1973) and Lall and Streeten (1977). The latter study provides anextensive review of the debate that emerged in the 1970s and offers one of the first empiricalanalyses on the effects of FDI on developing countries’ welfare. This question has attracted renewedinterest among policymakers in developing countries as their economies have become increasinglyopen to foreign investment over the last decade.

2

short-term unemployment due to corporate restructuring and increased marketconcentration. Clearly, coherence between different sets of policies, institutionaland regulatory conditions and the availability of skilled labour and infrastructure

also affect a country’s ability to reap the full benefits of FDI. There arenonetheless divergent views on how public policy can help maximise the benefits(and minimise the costs) of FDI in order to meet a country’s development needs.

This debate appears to have reached new heights at the beginning of the newmillennium. A series of “globalisation backlash” demonstrations from Seattle to

Genoa over the past two years expressed opposition to further liberalisation ofinternational trade and investment. Slaughter (2000) attempts to explain theforces behind this phenomenon in the United States, the country whose economy

is supposed to have benefited most from globalisation2. His empirical analysishighlights the importance of the “skills-preferences” cleavage among US workersand the breadth of anti-globalisation sentiments that it implies. In contrast, many

developing and transition economies have been attracting foreign investors, oftenthrough direct incentives, to help modernise their antiquated telecommunicationand other infrastructure and to kick-start new industries. Indeed, incentive-based

competition for FDI has become a global phenomenon, involving governments atall levels (national and sub-national) in both OECD and non-OECD countries(Oman, 2000).

Under these circumstances, it is important to inform the discussion bydrawing lessons from country experiences and case studies available in the

literature and to assist governments in identifying the conditions and policyrequirements for maximising the benefits of FDI and minimising its risks andpotential costs. The question is not merely academic, as this debate has important

implications for concerted international efforts currently under way both at theUnited Nations (to achieve the “Millennium Development Goals”) and at the WTO(to launch a new round of trade negotiations)3. Analytical work on the role of FDI

in development is also expected to contribute to the development and maintenanceof open policies towards FDI. A crucial dimension of this work, therefore, is an

2 In 1999 the United States became the world’s largest net recipient of FDI (inflows minus outflows),registering a net inflow of $124 billion, compared with $38 billion in China, the second largest(UNCTAD, 2000, Annex Tables B.1 and B.2).3 WTO Members successfully launched a new trade round at the Fourth Session of the MinisterialConference held in Doha last November. The relationship between trade and investment is, however,one of several issues that remain politically so sensitive that “negotiations will take place after theFifth Session of the Ministerial Conference on the basis of a decision to be taken, by explicitconsensus, at that Session on modalities of negotiations” (WT/MIN(01)/DEC/W/1. Para. 20).

3

assessment of why some countries are better able to take advantage of the gainsfrom liberalisation than others.

1.1　The Role of FDI in Development

In the development context, FDI is often regarded as a politically sensitive

and complicated issue4. The main reason for the political sensitivity of FDI, asopposed to domestic private investment, is that the former is “not only owned andcontrolled by private groups in pursuit of private profits but also by private

interests that are non-resident to boot” ( Reuber et al., 1973, p. 16). The politicaland social concerns arising from this simple fact were probably the decisive factorin determining the attitudes and policies towards FDI that prevailed in

developing countries from the 1970s through the mid-1980s (ibid., pp. 15-17).Since then, many developing countries have significantly, and in some casesdramatically, altered their attitudes and policies concerning FDI5. This alteration

is closely linked to a fundamental shift in development policy from importsubstitution to export promotion, and more specifically in the design ofgovernment policies for attracting the type of FDI that is most desired.

In this conjunction, it should be recalled that much of the FDI flowing intodeveloping countries in the early years was attracted by the availability of natural

resources. This traditional type of FDI has different implications for growth in thehost country than do other types of FDI, such as export-oriented manufacturingFDI. This point was empirically tested by Hiemenz et al. (1991), whose regression

analyses used a data sample covering 26 developing countries over the 1979-88period. Their results indicate that natural resource-oriented FDI, in contrast tomanufacturing FDI, tends to be undertaken independently of macroeconomic

conditions and the degree of product market distortions in the host country.

As exemplified by data on outward FDI by US firms, the sectoral composition

of the FDI stock does vary substantially between resource-rich and resource-poorhost economies (Table 1.1). In Indonesia, for instance, 90 per cent of the US FDI

4 A case in point is a critical review of Reuber et al. (1973) by Lall (1974), which demonstrates thatacademic views regarding the role of FDI in development were extremely divergent in the 1970s.While the degree of divergence appears to have narrowed considerably over the last 30 years, thissubject remains politically sensitive, particularly for some developing countries.5 A telling example in this respect is China’s reform experience since the late 1970s, and notably itsgradual shift in FDI policy since the mid-1980s. For further discussion, see Fukasaku and Wall(1994) and Fukasaku et al. (1999). See also Lemoine (2000) and Démurger (2000) for a detailedanalysis of the importance of FDI for China’s trade and growth.

4

stock was in petroleum in 1986, while in Chinese Taipei nearly three-quarters ofthis stock was in the manufacturing sector. It is interesting to note, however, thatbetween 1986 and 1998 the services sector (including the telecommunication and

power industries) considerably increased its relative share and became a mainrecipient of US FDI in several economies, notably Japan, Chinese Taipei, thePhilippines and Singapore, whereas in China it was the manufacturing sector

that expanded its relative share during the same period. Following the 1997-98financial crisis, the relative importance of the petroleum sector increasedmarkedly in resource-rich countries such as Indonesia and Thailand, and to a

lesser extent in Malaysia6.

6 See Fan and Dickie (2000) and Thompson and Poon (2000) for further discussion on the importanceof FDI for ASEAN economies.

5

Table 1.1. US Direct Investment Position in Selected Asian Economies, by Sector

Host economySector 1986 1994 1998 2000 1986 1994 1998 2000 1986 1994 1998 2000

All sectors 11,839 37,027 41,423 55,606 183 1,699 6,350 9,577 1,003 3,882 6,295 7,737 Petroleum 2,712 6,124 4,396 (D) (D) 675 939 1,846 -11 (D) 49 60 Manufacturing 5,560 15,844 11,428 15,173 43 765 3,862 5,663 745 2,459 3,324 3,692 Services 3,436 14,159 25,311 34,753 (D) 221 1,018 1,474 250 1,291 2,783 3,700 Others 131 900 288 (D) 7 38 531 594 19 (D) 139 285

All sectors 100 100 100 100 100 100 100 100 100 100 100 100 Petroleum 23 17 11 (D) (D) 40 15 19 -1 (D) 1 1 Manufacturing 47 43 28 27 23 45 61 59 74 63 53 48 Services 29 38 61 62 (D) 13 16 15 25 33 44 48 Others 1 2 1 (D) 4 2 8 6 2 (D) 2 4

Host economySector 1986 1994 1998 2000 1986 1994 1998 2000

All sectors 4,227 11,986 17,548 23,308 897 3,612 7,365 9,432 Petroleum 235 552 597 202 8 88 (D) (D) Manufacturing 553 1,902 2,597 3,283 341 1,391 2,712 3,954 Services 3,287 9,015 11,366 16,396 526 2,082 (D) 3,563 Others 152 517 2,988 3,427 22 51 -24 (D)

All sectors 100 100 100 100 100 100 100 100 Petroleum 6 5 3 1 1 2 (D) (D) Manufacturing 13 16 15 14 38 39 37 42 Services 78 75 65 70 59 58 (D) 38 Others 4 4 17 15 2 1 0 (D)

Japan China Chinese Taipei

Hong Kong Korea, Rep.

($ million)

(percentage)

($ million) ($ million)

(percentage)

($ million)

(percentage)

($ million)

(percentage)

(percentage)

6

Table 1.1. US Direct Investment Position in Selected Asian Economies, by Sector (continued)

Host economySector 1986 1994 1998 2000 1986 1994 1998 2000 1986 1994 1998 2000

All sectors 3,369 5,015 8,104 11,605 1,019 2,382 5,629 5,995 1,274 2,374 3,931 2,910 Petroleum 3,044 4,341 5,115 8,440 613 396 1,048 1,252 123 (D) 283 1 Manufacturing 98 181 275 273 301 1,582 3,679 3,411 558 1,167 1,558 1,207 Services (D) 234 (D) 673 87 351 914 (D) 428 (D) 1,854 1,394 Others (D) 259 (D) 2,219 18 53 -12 (D) 165 67 236 308

All sectors 100 100 100 100 100 100 100 100 100 100 100 100 Petroleum 90 87 63 73 60 17 19 21 10 (D) 7 0 Manufacturing 3 4 3 2 30 66 65 57 44 49 40 41 Services (D) 5 (D) 6 9 15 16 (D) 34 (D) 47 48 Others (D) 5 (D) 19 2 2 0 (D) 13 3 6 11

Host economySector 1986 1994 1998 2000 1986 1994 1998 2000

All sectors 2,481 10,972 17,550 23,245 1,152 3,762 5,209 7,124 Petroleum 455 2,127 2,636 1,718 726 1,185 1,209 2,666 Manufacturing 1,456 5,316 7,045 11,834 274 1,341 2,313 2,767 Services 543 3,332 7,788 9,411 143 842 1,236 1,459 Others 27 197 81 282 9 394 451 232

All sectors 100 100 100 100 100 100 100 100 Petroleum 18 19 15 7 63 31 23 37 Manufacturing 59 48 40 51 24 36 44 39 Services 22 30 44 40 12 22 24 20 Others 1 2 0 1 1 10 9 3

Note : (D) Suppressed to avoid disclosure of data on individual companies.Sources : The figures for 1986 and 1994 were taken from Petri and Plummer (1998, Table 7.1); for other years, see US Departmentof Commerce, Bureau of Economic Analysis, International Investment Division.

Malaysia Philippines

Singapore Thailand

($ million)

(percentage)

($ million)

(percentage)

($ million)

(percentage)

($ million) ($ million)

(percentage) (percentage)

Indonesia

7

This heterogeneity in the sectoral distribution of FDI, which reflects thediffering motivations of investors, is what makes policy discussion on FDIcomplicated from the host country’s point of view. The present study focuses on

the non-traditional type of FDI (in manufacturing and services) and itsimplications for sustained growth in developing countries.

Figure 1.1 illustrates the role of FDI in development in its simplest form.This schematic diagram depicts the flow of capital, technology and managerialknow-how from parent companies to their foreign affiliates and to local firms

within and between industries. From the standpoint of host-country interests, thecentral question is the extent to which FDI contributes to long-term growth indeveloping countries through both direct effects (increased investment and trade)

and indirect ones (technological spillovers to local firms, including privatised ones,and to local workers). Host-country policies and regulations are also important forboth attracting FDI and maximising the benefits from it7. As this is basically an

empirical question, much of this study is devoted to a review of recent empiricalstudies available in the literature.

Figure 1.1. The Role of FDI in Development: Host-country Interests

7 The issue of home-country interests is beyond the scope of this study and will not be discussed here.

Vertical and Labourhorizontal Traininglinkages

Governmentpolicy &

regulations

Localfirms andworkers

MNEs

CapitalTechnologyKnow-how

Parentcompanies

Foreignaffiliates

A host country

8

The rest of this study is organised as follows. ChapterⅡ presents a statisticaloverview of major trends in FDI flows from the global and regional perspectives.This chapter is intended to set the stage for subsequent discussions under the

following five headings (Chapters Ⅲ to Ⅶ):

• the FDI-growth nexus;• FDI-trade linkages;• FDI and technology transfer;• FDI, privatisation and corporate governance; and• host-country policies for attracting FDI.

The study concludes by summarising major findings and policy lessons. The

following paragraphs briefly describe the key questions addressed in individualchapters.

1.2　The FDI-Growth Nexus

Does FDI contribute relatively more to growth than domestic investment?

The answer to this question seems to be less controversial in theory than inpractice. As noted above, FDI can be seen as an important vehicle for the transferof capital, technology and knowledge to host countries, and hence as generating

more growth opportunities than domestic investment8. In practice, however,opinions differ regarding its impact on growth. The growth-enhancing effect ofFDI may depend in part on whether FDI “crowds out” or “crowds in” domestic

investment. It may also depend crucially on the absorption capacity of a hostcountry, as the efficient use of new technologies requires a minimum level ofhuman capital on the recipient side. The literature on this FDI-growth nexus has

grown rapidly over the past several years. Chapter Ⅲ reviews existing empiricalstudies on this topic and discusses implications for policy.

1.3　FDI-Trade Linkages

Does FDI lead to trade, or does trade lead to FDI? Are FDI and trade

substitutes or complements? These questions have been addressed repeatedly inthe trade literature in different policy contexts, and a considerable amount ofwork has been dedicated to testing alternative hypotheses on the relationship

between FDI and trade. On the one hand, the “complementarity hypothesis” is

8 This explains why China is so eager to attract FDI, even though the country has one of the highestsaving rates in the world.

9

based on the premise that an MNE’s decision to invest abroad may be encouragedby significant bilateral trade between the home and host countries. There is alsosome evidence that FDI tends to enhance bilateral trade between Japan and

Asian developing countries (Kawai and Urata, 1995; Urata, 2001). On the otherhand, the “substitution hypothesis” affirms that FDI reduces bilateral trade byreplacing home-country exports with local production in the host country. Chapter

Ⅳ takes stock of recent empirical studies.

1.4　FDI and Technology Transfer

Many developing countries view FDI as one of the most important means ofacquiring new technologies and improving productive efficiency through

technological spillovers. A central question here is the extent to which FDIcontributes to the productivity growth of local firms. This is a key issue in thecurrent debate on how to strengthen the trade capacity of poor countries. In the

post-crisis context, it has also attracted renewed interest among Asianpolicymakers, with a view to enhancing local technological capabilities in theregion. Chapter Ⅴ reviews and discusses the empirical literature on the

relationship between FDI and technology transfer from the developmentperspective.

1.5　FDI, Privatisation and Corporate Governance

Should privatisation be opened up to foreign investors? What are the

implications of increased foreign participation in domestic business activities forcorporate governance in host countries? This is a new — and politically sensitive— topic for host countries, notably Asian countries in the post-crisis context.

Recent experiences in Latin America as well as in a number of OECD countriesprovide some useful lessons for them, since informed analysis and policydiscussion on these questions remain limited in Asia (Fukasaku, 2001). Chapter

Ⅵ attempts to synthesise the materials available and discusses some policy issues.

1.6　Host-government Policies for Attracting FDI

Over the past decade, attracting FDI has become a leading item on nationaland regional policy agendas in both OECD and developing countries. Asia is no

exception in this regard. Some argue, for instance, that the creation of the ASEANFree Trade Area (AFTA) and ASEAN Investment Area (AIA) may be construed asa strategic response by the ASEAN countries to China’s ascendancy as the main

destination of FDI flowing into the region during the 1990s. According to JBIC’s

10

latest survey of Japanese multinationals, 56.7 per cent of the 469 Japanesemanufacturing firms surveyed regard China as a more attractive productionlocation than ASEAN, while only 10.2 per cent of them hold the opposite view

(JBIC, 2001, p. 13). Similarly, a recent proposal for forging strategic trade linksbetween these two economies may be interpreted as a joint initiative to enticeforeign investors from other regions. Many other regional trade and co-operation

arrangements are currently in place or under consideration. Chapter Ⅶ addressesthe question of policy competition for attracting FDI.

11

Chapter Ⅱ Trends in FDI: Global and Regional Perspectives

Foreign direct investment (FDI) has been one of the defining features of

globalisation and has substantially reshaped the international businessenvironment. A critical element of this phenomenon is the speed of change. Overthe past 20 years, the dollar value of global FDI outflows has increased much

faster than that of world merchandise exports, with a particularly strong surgerecorded in 1986-90 and again in 1996-2000 (Figure 2.1). An underlying reason forthis rapid expansion in FDI flows since the mid-1980s is the fundamental shift in

policy regimes towards foreign investment at both the national and internationallevels. On the national front, a large number of countries, in OECD and non-OECD areas alike, have introduced substantial changes in their FDI regulations

to create a more favourable environment for foreign investment. Chapter Ⅶ takesa closer look at such regulatory changes in selected host economies in Asia andLatin America.

At the same time, efforts have continued at the international level to provideproper protection for foreign investment. First, bilateral investment treaties

(BITs), which provide legal security to foreign investors and their investments,have become increasingly important instruments for protecting and promotinginvestment flows. Most existing BITs were concluded in the 1990s, in parallel

with the rise in investment flows: during the three decades leading up to 1990,only 500 BITs had been signed, whereas by the end of the 1990s this number hadalmost quadrupled. It is also noteworthy that in 1999 the vast majority of BITs

were concluded between developing countries (UNCTAD, 2000). Second,international standards for the treatment of foreign investors have beenstrengthened in terms of national treatment, transparency in incentives and

disincentives, codes of business conduct and the avoidance of double taxation (seeBox 2.1). These favourable policy developments give firms greater freedom inmaking strategic decisions on where to produce and how to serve different

markets from a global perspective.

12

Figure 2.1. Trends in World Merchandise Exports and FDI Outflows(average annual growth rates)

Sources: UNCTAD, World Investment Report (various years), and IMF, InternationalFinancial Statistics .

Box 2.1. International Investment Instruments

Although there are no universal rules governing international investment, OECDMember countries are committed to providing non-discriminatory treatment to inwarddirect investment and related financial flows by virtue of the legally binding OECDCodes of Liberalisation. The 35 countries that adhere to the OECD Declaration onInternational Investment and Multinational Enterprises have also undertaken a politicalcommitment to accord national treatment to established foreign direct investors, topromote voluntary standards of corporate responsibility by multinational enterprises, toencourage restraint in the use of investment incentives and to avoid the imposition ofconflicting regulatory requirements on multinational enterprisesa. These instrumentshave provided an effective framework for international co-operation and have served tounderpin the liberalisation achieved in recent decades.

a All 30 OECD Member countries have adhered, as well as Argentina, Brazil, Chile, Estonia andLithuania. The OECD encourages non-members to adhere to this Declaration, which includes theGuidelines for Multinational Enterprises.

Multinational enterprises ( MNEs) have long played an important role inmany countries, both developed and developing, but their importance hasincreased still further with the recent surge in global FDI flows. Today, over

63 000 parent companies world-wide have established about 690 000 affiliates incountries other than their own, and this stock of inward FDI was valued atroughly $4 800 billion in 1999. Foreign affiliates of MNEs are estimated to have

generated total gross product of more than $3 000 billion and total employment ofover 40 million in host countries. While 90 per cent of all parent companies are

-5

0

5

10

15

20

25

30

35

1981-85 1986-90 1991-95 1996-2000

Period

Gro

wth

(%

)

World merchandise exports World FDI outflows

13

located in OECD countries, more than half of all foreign affiliates operate in non-OECD economies, providing a major source of industrial production andemployment in a number of developing host countries9.

Although the available data are fragmentary and incomplete, the relativeimportance of foreign affiliates in host economies can be seen in Table 2.1. This

table presents information for 1996 (or the latest available year) on foreignaffiliates operating in manufacturing industry in 16 OECD Member countries, interms of the number of enterprises and employees as well as the value of

production, exports and imports10. It is evident from this table that by the mid-1990s affiliates of foreign-owned MNEs were already playing a significant part inindustrial activity in most of these countries (with the notable exception of Japan).

Foreign affiliates had a particularly strong presence in economies such as Canada,Hungary and Ireland, accounting for more than half of total industrial production.The table also suggests that foreign affiliates of MNEs operating in

manufacturing industry are on average larger and more trade-oriented than theirdomestic counterparts.

9 These figures are taken from UNCTAD (2000, Tables I.1 and I.4).10 The original data are extracted from OECD (2000) CD-ROM. It should be noted that internationalcomparison of FDI trends still poses a major challenge to researchers, because the official dataprovided by national authorities are not strictly comparable. See, for example, Feenstra (1998) forfurther discussion.

14

Table 2.1. Foreign Affiliates in Manufacturing Industry of Selected OECD Countries(1996 or latest available year) (a)

Notes : (1) "Manufacturing industry" is defined as ISIC Rev. 3, and national currrencies are converted into

US dollars using period-average exchange rates. (2) 1995. (3) 1994. (4) 1993. (5) Refers to majority foreign-owned firms. (6) Refers to majority foreign-owned firms with 100 or more employees. (7) Based on the Annual Industrial Statistics, which are establishment-level data. (8) All firms with foreign ownership of over 10 per cent of the share capital. (9) Includes all local units of multi-location enterprises (with more than three employees) where 50

per cent or more of the share capital is held by non-Irish residents.(10) Refers to all Italian enterprises in which a foreign person owned or controlled a direct or

indirect interest of 50 per cent or more at the end of the fiscal year.(11) Refers to majority foreign-owned establishments.(12) Refers to majority foreign-owned non-financial firms.(13) Refers to non-bank firms in which 10 per cent or more of the voting shares are foreign-owned.(14) On a full-time equivalent basis.(15) Turnover.(16) Refers to total merchandise trade.(17) Authors' estimation.n.a. not available.Source: Fukasaku and Kimura (2001, Table 1).

Units % of Units % of $ % of $ % of $ % of national national million national million national million national

total total total total total(2)

Canada (5) 1,816 26.4 n.a. n.a. 193,272 50.9 75,105 49.4 n.a. n.a.(14)

Czech Republic (6) 268 12.0 149,847 15.4 8,719 24.3 n.a. n.a. n.a. n.a.

Finland (3), (7) 287 5.4 29,606 8.6 5,417 9.0 2,866 10.7 n.a. n.a.(14)

France (5) 2,787 12.6 742,663 25.8 157,141 28.8 70,922 35.2 n.a. n.a.(15)

Germany (5) 1,454 4.0 453,000 6.9 179,226 12.8 n.a. n.a. n.a. n.a.(15) (16) (16)

Hungary (8) 4,312 12.8 297,448 35.6 20,583 62.4 10,737 68.5 12,716 70.2

Ireland (9) 728 15.8 106,410 47.0 38,587 66.4 34,463 83.9 8,999 75.4(14) (15)

Italy (2), (10) 1,403 0.3 423,590 8.9 114,456 11.9 n.a. n.a. n.a. n.a.(14) (15)

Japan (5) 285 0.1 86,469 0.8 45,872 1.2 5,994 1.5 10,342 4.0(16) (17) (16) (17)

Mexico (4), (5) 1,927 n.a. 906,614 n.a. 42,320 n.a. 11,174 21.5 18,081 27.7

Netherlands (5) 844 2.6 160,487 19.0 67,038 29.7 42,957 42.4 33,907 43.2

Norway (11) 516 4.7 40,348 14.3 11,514 19.0 n.a. n.a. n.a. n.a.(14) (15)

Sweden (12) 757 2.3 134,372 19.9 34,294 20.8 16,238 20.7 7,506 30.3

Turkey (11) 170 1.6 58,422 5.6 11,831 12.7 n.a. n.a. n.a. n.a.

United Kingdom (5) 2,686 1.6 815,161 19.2 229,537 33.2 n.a. n.a. n.a. n.a.(17) (15) (17) (16) (17) (16) (17)

United States (13) 2,950 n.a. 2,213,600 11.9 552,000 14.9 140,886 22.5 268,673 33.8

ImportsNo. of enterprises No. of employees Production Exports(1) (2) (3) (4) (5)

15

The combination of the prominence of MNEs in industrial activity and thegrowing importance of FDI as a vehicle for international technology transfer hasrecently drawn the attention of policymakers to the potential benefits — and costs

— of FDI. This chapter presents an overview of major trends in FDI flows fromthe global and regional perspectives. It is intended to set the stage for the policyanalyses and discussions in the subsequent chapters.

2.1　A Global Surge in FDI since 1993

The rapid expansion in global FDI flows since 1993 stands in sharp contrastto the annual movement of world merchandise trade (Figure 2.2). Over the 1992-99 period, outflows of FDI increased fivefold, from just over $200 billion to around

$1 000 billion, while world exports rose by less than 50 per cent. In 2000, FDIoutflows rose by a further 15 per cent to $1 150 billion.

Figure 2.2. World Merchandise Trade and FDI Flows, 1989-2000(value index, 1989=100)

Note: World merchandise trade is defined as the average of exports and imports, FDI flows as theaverage of outflows and inflows.

Sources: see Figure 2.1.

A key feature of the current FDI boom is that an increasingly large

proportion of FDI takes the form of cross-border mergers and acquisitions (M&As),including acquisitions of public enterprises (i.e. privatisation) in host economies

0

100

200

300

400

500

600

700

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Year

Val

ue in

dex

World merchandise trade World FDI flows

16

(Figure 2.3)11. It is no exaggeration to say that the current FDI boom has beenlargely fuelled by international M&A activity. The annual average value of cross-border M&As has jumped more than sixfold in recent years, from $132 billion in

1993-95 to over $810 billion in 1998-2000. During the latter sub-period, cross-border M&As accounted for 80 per cent of global FDI inflows.

Figure 2.3. Trends in FDI Inflows, Cross-border M&As and Privatisation

Sources: UNCTAD, World Investment Report (various years) and OECD (2001e).

Cross-border M&A transactions are heavily concentrated in OECD countries,

which accounted for over 90 per cent of the world total in 1998-2000 (Table 2.2).Within the OECD area, the share of European Union (EU) member states hasincreased steadily over the last ten years, from 35 per cent in 1988-90 to

46 per cent in 1998-2000. This is primarily due to industrial restructuring in thecontext of the European Single Market Programme (Dunning, 1998). Sleuwaegen(1998) also points out that service sectors, such as business services, distribution,

and banking and finance, have gained in relative importance in the recent M&Awaves in Europe, together with the engineering and chemicals industries.

11 The number of “real” mergers is so low (less than 3 per cent of total cross-border M&As in 1999)that, for the purposes of this study, “M&A” may be taken to mean acquisitions of 10 per cent or moreof a firm’s voting shares. Acquisitions of less than 10 per cent of the voting stock are classified asportfolio investment and not considered here as FDI.

0

200

400

600

800

1000

1200

1400

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Year

$ bi

llion

FDI Inflows Cross-border M&As Privatisation

17

Table 2.2. Cross-border M&As by Region/Economy of Seller(three-year average, $ billion and percentages)

Annual average1988-90 1993-95 1998-2000

World total (value, $ billion) 135.5 132.3 813.8

% shares

OECD regions (30) 94.7 89.5 91.1

Asia/Pacific (4) 4.7 7.2 4.6

Europe (23) 37.0 46.8 49.1 EU (15) 34.6 42.6 46.4

North America (3) 52.9 35.5 37.3

Non-OECD Regions 5.3 10.5 8.9

Asia/Pacific 1.8 4.6 1.8 East Asia & Pacific 1.8 4.3 1.6 China 0.0 0.4 0.2

ASEAN (10) 0.7 1.7 0.9

South Asia 0.0 0.2 0.2

Europe & Central Asia 0.0 0.5 0.4

Latin America & Caribbean 2.9 4.8 5.9Mercosur (4) 1.7 2.0 4.0

Middle East & North Africa 0.1 0.3 0.4

Sub-Saharan Africa 0.4 0.7 0.3

Region/economy

Notes :1. The "OECD regions" are OECD Asia/Pacific (4), OECD Europe (23)

and North Anerica (3).2. The "OECD Asia/Pacific" countries are Australia, Japan, Rep. of

Korea and New Zealand.3. "OECD Europe" comprises the EU (15), Czech Rep., Hungary, Iceland,

Norway, Poland, Slovak Rep., Switzerland and Turkey.4. The "EU (15)" consists of Austria, Belgium-Luxembourg, Denmark,

Finland, France, Germany, Greece, Ireland, Italy, the Netherlands,Portugal, Spain, Sweden and the United Kingdom.

5. "North America" comprises Canada, the United States and Mexico.6. "ASEAN (10)" comprises Brunei Darussalam, Cambodia, Indonesia,

Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand and VietNam.

7. The "Mercosur (4)" are Argentina, Brazil, Paraguay and Uruguay.The regional groupings as noted above are defined as if their membercountries remain the same throughout the period.

Sources: UNCTAD, World Investment Report (various years).

18

There is substantial inter-regional variation in the importance of cross-border M&A transactions relative to FDI inflows (Table 2.3). Note that these twosets of data are not directly comparable. Figures on FDI are based on balance-of-

payments statistics, while those on cross-border M&As are not. Conceptually, FDIis composed of cross-border M&As and greenfield investment, but in practice theavailable data rarely allow us to distinguish between these two types of

international investment12. Particularly troublesome is the fact that the value ofcross-border M&As includes funds raised on local and international markets,while such funds are not, by definition, part of FDI. This problem appears to be

far more serious in the case of developed countries with advanced domestic capitalmarkets than in the case of developing countries, where cross-border corporatesales are likely to be financed by FDI flowing from purchasing countries13. With

this caveat in mind, it can still be argued that the most marked difference is thatbetween OECD and non-OECD regions. Among the latter, Latin America and theCaribbean, and in particular Mercosur, have long embraced cross-border M&As as

the principal mode of FDI inflows. In 1998-2000, M&As accounted for 59 per centand 71 per cent respectively of total FDI flows into these two regions. This is dueto the large-scale privatisation programmes, including privatisation of public

utilities, which have been implemented in Argentina, Brazil and other countries ofthe region (see Chapter Ⅵ). In contrast, two regions in Asia and the Pacific,namely ASEAN and South Asia, have jumped onto this M&A bandwagon more

recently, in the aftermath of the 1997-98 financial crisis. Among majordeveloping-country recipients of FDI, China remains an exception in this respect.

12 The United States is a major exception.13 The statistical discrepancies are clearly marked in the case of the OECD Asia-Pacific region in1998-2000 and North America in 1988-90 and 1998-2000, as these three cases are off the scale (morethan 100 per cent).

19

Table 2.3. Cross-border M&As as a Percentage of FDI Inflows(percentages)

Notes and sources: see Table 2.2.

According to the latest UNCTAD forecast (September 2001), the current FDIboom appears to have come to an end in 2001. The dollar value of global FDI flows

(based on recipient-country data) is likely to have declined by 40 per cent duringthe year, the “first drop since 1991 and the largest over the past three decades”(TAD/INF/PR21/ Rev. 1, 18 September 2001). This decline is largely due to a

49 per cent drop in FDI flows to developed countries as a result of the fall-off incross-border M&A activity. For developing regions, in contrast, the decline in FDIinflows is likely to be modest: a drop of some 6 per cent is predicted.

2.2　Regional Trends

OECD regions as a whole continued to be the primary source of FDI,accounting for more than 90 per cent of total outflows in 1998-2000, with somefluctuations during the past decade (Table 2.4). Among major OECD regions, the

15 member states of the European Union were collectively the largest supplier ofFDI, followed by two North American OECD Members, Canada and the UnitedStates. In contrast, the share of Asia-Pacific OECD Member countries fell

dramatically, from 22 per cent in 1988-90 to merely 3.5 per cent in 1998-2000,

Annual average1988-90 1993-95 1998-2000

World total 73 49 80

OECD regions (30) 80 67 92

Asia/Pacific (4) 68 85 144

Europe (23) 59 61 83 EU (15) 58 63 84

North America (3) 110 71 101

Non-OECD regions 27 15 35

Asia/Pacific 16 10 15 East Asia & Pacific 16 9 14 China 0 2 4

ASEAN (10) 11 11 47

South Asia 1 17 52

Europe & Central Asia 50 16 26

Latin America & Caribbean 58 35 59Mercosur (4) 73 35 71

Middle East & North Africa 7 12 44

Sub-Saharan Africa 26 25 31

Region/economy

20

largely owing to the diminishing role of Japan as a source country relative to itsEuropean and North American counterparts14.

Table 2.4. FDI Outflows by Home Region/Economy($ billion and percentages)

Annual average 1988-90 1993-95 1998-2000

World total (value, $ billion) 210.2 295.2 955.9 % shares

OECD regions (30) 94.8 85.4 93.2

Asia/Pacific (4) 22.3 8.2 3.5

Europe (23) 58.0 47.0 71.9 EU (15) 53.9 42.7 67.9

North America (3) 14.4 30.2 17.9

Non-OECD regions 5.2 14.6 6.8


ASEAN (10) 0.6 2.4 0.5



Latin America & Caribbean 0.9 2.3 1.4 Mercosur (4) 0.2 0.6 0.4



Home region/economy


Among individual home countries of FDI, the G7 countries and several other

European countries maintained their dominant positions throughout the 1990s(Table 2.5). The very high concentration of FDI outflows hardly changed, as theten largest home countries continued to supply more than 80 per cent of total

outflows. Only three non-OECD economies — Hong Kong-China, Chinese Taipeiand Chile — ranked among the 20 largest home economies of FDI in 1998-2000.

14 Over the past 15 years, the policy debate on Japanese FDI outflows has centred on the question ofthe “hollowing out” of manufacturing industries, as overseas production facilities expanded inresponse to the yen’s appreciation against the dollar after the Plaza Accord in 1985. After the 1997-98 crisis, however, Japanese FDI outflows to East Asia started to fall. For a detailed discussion ofFDI issues from the Japanese perspective, see inter alia Tejima (2000a and 2000b) and Sazanami etal. (2001).

21

Table 2.5. World’s 20 Largest Home Economies of FDI(annual average, $ billion)

Sources: see Table 2.2.

In contrast, non-OECD regions as a whole had become major recipients of

FDI by the mid-1990s. They received 34 per cent of total inflows in 1993-95, up 20percentage points from the 1988-90 level ( Table 2.6). East Asia and, to a lesserextent, the Latin America and Caribbean region had emerged as the most

favourable places for foreign investment outside the OECD area. Subsequently,however, the share of non-OECD regions declined substantially as a result of the1997-98 financial crisis, which had a severe impact on several East Asian

economies. The effect of the crisis is evident in the sharp drop in the relative shareof ASEAN member states and China as destinations of FDI flows in 1998-2000, incontrast to the steady rise in the relative share of Mercosur countries throughout

the period concerned.

Rank 1998-2000 Rank 1991-93

1 United Kingdom 192.5 1 United States 49.12 United States 137.6 2 Japan 26.13 France 113.9 3 France 25.04 Germany 82.3 4 United Kingdom 20.75 Belgium-Luxembourg 78.0 5 Germany 20.26 Netherland 57.2 6 Netherland 13.37 Spain 38.2 7 Hong Kong, China 9.68 Hong Kong, China 33.1 8 Belgium-Luxembourg 7.59 Canada 32.3 9 Italy 7.510 Switzerland 31.4 10 Switzerland 7.3

Total of above 796.7 Total of above 186.3(% of grand total) (83) (% of grand total) (85)

11 Sweden 28.6 11 Canada 5.012 Japan 26.6 12 Spain 3.213 Denmark 22.0 13 China 3.114 Finland 16.1 14 Sweden 2.715 Italy 10.4 15 Chinese Taipei 2.116 Chinese Taipei 5.0 16 Australia 1.917 Chile 4.1 17 Denmark 1.818 Portugal 4.0 18 Singapore 1.519 Korea, Rep. 3.7 19 Austria 1.520 Ireland 3.4 20 Korea, Rep. 1.3


Home economy Home economy

22

Table 2.6. FDI Inflows by Host Region/Economy($ billion and percentages)

Annual average 1988-90 1993-95 1998-2000

World total (value, $ billion) 186.7 268.8 1 012.8

% shares

OECD regions (30) 85.4 66.0 79.6 Asia/Pacific (4) 5.0 4.2 2.6 Europe (23) 45.4 37.4 47.5 EU (15) 43.1 33.1 44.3

North America (3) 35.0 24.4 29.6 Non-OECD regions 14.6 34.0 20.4


ASEAN (10) 4.7 7.6 1.5



Latin America & Caribbean 3.7 6.8 8.0 Mercosur (4) 1.7 2.7 4.5



Host region/economy


Where individual host economies are concerned, there have been some major

changes in the preferences of foreign investors over the past decade ( Table 2.7).Malaysia, Singapore and Thailand, three emerging economies of East Asia, havedropped out of the list of the 20 largest recipients of FDI, being replaced by Brazil

and two small European OECD countries, Finland and Ireland. An equallynoteworthy development is that both Japan and the Republic of Korea (hereafterreferred to as Korea) have entered the ranking for the first time, becoming

attractive locations for foreign investment in the post-Asian crisis era.

23

Table 2.7. World’s 20 Largest Recipient Economies of FDI(annual average, $ billion)


The unprecedented FDI boom enjoyed by Hong Kong-China over the last two

years should also be mentioned. Inflows to the territory jumped from $24.6 billionin 1999 to $64.4 billion in 2000, surpassing mainland China’s record of$40.8 billion. At the same time, outflows from the territory surged from

$19.3 billion to $63.0 billion. As a result, Hong Kong-China’s inflows and outflowsin 2000 accounted for 52 per cent and 79 per cent respectively of total FDI flowsinto and out of the East Asia and Pacific region (excluding OECD Members of the

region). While this may be due in part to the so-called “round-tripping”phenomenon linking the territory’s economy to other offshore financial centres,China’s imminent accession to the WTO and prominent cross-border M&A deals

in the telecommunications sector have certainly boosted FDI flows to Hong Kong-China (UNCTAD, 2001, pp. 24-25).

Overall, the experience of the 1990s suggests that regional patterns of FDIflows can change dramatically over the medium term. Between 1991-93 and 1998-2000 there were two major developments which deserve special attention ( Table

2.8). First, the United States, which on a net basis (outflows minus inflows) hadbeen the world’s second-largest source country, after Japan, became the largest

Rank 1998-2000 Rank 1991-93

1 United States 250.2 1 United States 27.72 United Kingdom 94.7 2 France 17.83 Germany 85.4 3 United Kingdom 15.54 Belgium-Luxembourg 76.5 4 China 14.35 Netherland 45.2 5 Spain 11.86 China 41.6 6 Belgium-Luxembourg 10.57 France 40.7 7 Netherland 7.58 Canada 37.0 8 Mexico 5.39 Hong Kong, China 34.6 9 Singapore 4.8

10 Sweden 34.0 10 Malaysia 4.7


11 Brazil 31.1 11 Australia 4.612 Spain 22.2 12 Canada 4.013 Argentina 14.2 13 Sweden 3.414 Ireland 14.1 14 Italy 3.315 Mexico 12.2 15 Argentina 3.116 Denmark 11.5 16 Bermuda 2.817 Switzerland 9.9 17 Germany 2.318 Korea, Rep. 8.7 18 Hong Kong, China 2.119 Finland 8.3 19 Thailand 2.020 Japan 8.1 20 Portugal 2.0


Recipient economy Recipient economy

24

net recipient of FDI. This about-face stands in sharp contrast to the continueddominance of five EU member states (France, Germany, Italy, the Netherlandsand the United Kingdom) and Switzerland as net exporters of FDI, although some

other EU countries (most notably, Belgium-Luxembourg and Spain) became newmajor suppliers of FDI on a net basis.

The second important development over the last ten years is that Chinaremains by far the largest developing-country recipient of FDI (see Box 2.2)15.Only a few emerging economies (other than China) succeeded in attracting a

sizeable amount of FDI on a net basis, though there were some changes in theranking of these economies over time. These observations suggest that the role ofhost-country characteristics must be taken into explicit account when examining

the relationship between FDI and growth, which is the subject of the next chapter.

15 The “special case” of China has been discussed in detail in the literature (see inter alia Hill andAthukorala, 1998, pp. 27-30).

25

Table 2.8. Net FDI Exporters and Importers

(annual average, $ billion)

1998-2000 1991-93

1 United Kingdom 97.8 1 Japan 24.3 2 France 73.2 2 United States 21.4 3 Switzerland 21.5 3 Germany 17.9 4 Japan 18.5 4 Hong Kong, China 7.5 5 Spain 16.0 5 France 7.2 6 Netherland 12.1 6 Netherland 5.8 7 Denmark 10.5 7 Switzerland 5.5 8 Finland 7.8 8 United Kingdom 5.2 9 Italy 3.5 9 Italy 4.2 10 Indonesia 2.6 10 Chinese Taipei 1.1 11 Chinese Taipei 2.3 11 Canada 1.0 12 Belgium-Luxembourg 1.5 12 Austria 0.7 13 Portugal 1.2 13 Korea, Rep. 0.5 14 South Africa 0.5 14 Denmark 0.4 15 Turkey -0.3 15 South Africa 0.1 16 New Zealand -0.3 16 Ireland 0.0 17 Russian Federation -0.9 17 Finland -0.2 18 Nigeria -0.9 18 Russian Federation -0.4 19 Hong Kong, China -1.5 19 Chile -0.4 20 Hungary -1.6 20 Venezuela -0.6 21 Chile -1.7 21 Saudi Arabia -0.6 22 Saudi Arabia -1.7 22 Nigeria -0.7 23 Malaysia -2.1 23 New Zealand -0.7 24 Austria -2.5 24 Sweden -0.7 25 Bermuda -2.9 25 Turkey -0.7 26 Germany -3.1 26 Poland -0.9 27 Thailand -3.5 27 Brazil -0.9 28 Venezuela -3.6 28 Portugal -1.5 29 Singapore -3.7 29 Indonesia -1.6 30 Canada -4.7 30 Hungary -1.7 31 Korea, Rep. -5.1 31 Thailand -1.8 32 Sweden -5.4 32 Australia -2.7 33 Australia -6.1 33 Argentina -2.9 34 Poland -7.7 34 Belgium-Luxembourg -2.9 35 Ireland -10.7 35 Bermuda -3.0 36 Mexico -10.8 36 Singapore -3.3 37 Argentina -12.7 37 Malaysia -3.9 38 Brazil -28.8 38 Mexico -5.0 39 China -39.4 39 Spain -8.6 40 United States -112.6 40 China -11.2

Economy Economy


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Box 2.2. Is China a Special Case?

Lee and Houde (2000), following John Dunning’s eclectic approach to thedeterminants of decisions on FDI location, identify six main characteristics of countriesthat constitute advantages in attracting FDI, along with the types of FDI flows theymight attract. The authors argue that China has all these advantages.

• Market size and growth prospects. Factors like market size, prospects for marketgrowth, the degree of development and per capita incomes of host countries areimportant determinants in the location decisions made by MNEs. Host countries withlarger markets, faster economic growth and a higher degree of economic developmentwill offer better opportunities for enterprises to exploit their ownership advantagesand to realise economies of scale. FDI attracted by these advantages is called “market-oriented” FDI.

• Natural and human resource endowments, including the cost and productivity oflabour. Factor cost advantages and the availability of natural and human resourceendowments are a driving force behind FDI. In particular, FDI oriented towardsexports (either back to the home country or to third countries) seeks to exploitcomparative advantages related to low labour costs or the abundance of naturalresources. Recently, attention has shifted from natural endowments of resources andlabour to acquired endowments of resources, such as intermediate goods and skilledlabour.

• Physical, financial and technological infrastructure. Differences in the quality ofinfrastructure, such as transportation and telecommunications, influence the decisionon FDI location not only among candidate countries but also among different regionswithin a country. FDI is more likely to flow to areas that are easily accessible andconsequently offer lower transportation costs.

• Openness to international trade and access to international markets. China’seconomic reform, open-door policy and other efforts to promote trade have attractedexport-oriented FDI. The country’s geographic position, adjacent to the region’sindustrial powerhouses Japan and Korea, is also a significant factor in attracting thistype of FDI.

• The regulatory and policy framework and policy coherence. General economic, politicaland social stability forms the background of a host country’s FDI policy. A transparentand well-functioning legal framework and business environment is of the firstimportance, since it lowers the (political) risk of doing business in an unfamiliarenvironment. Rules and regulations regarding the entry and operations of foreignfirms, as well as standards of treatment of foreign firms, are particularly relevant inthis respect. Chinese efforts to comply with international standards in the context ofWTO accession negotiations have certainly had a positive impact.

• Investment protection and promotion. Proper protection of investments is considered aminimum requirement for attracting FDI. There has been no case of expropriation offoreign investment in China since 1979, when the country opened up its economy toFDI. Like many other countries, China also offers investment promotion packages toattract FDI. Such incentive packages include tax and other financial incentives thataffect net profit rates, which appear to be the primary concern of foreign investors,and may thus influence the decision on where to locate FDI.

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Chapter Ⅲ The FDI-Growth Nexus

The conventional approach to examining the relationship between FDI and

growth relies on a variant of the so-called “resource-gap” model as the mainanalytical tool. In this model, developing countries find themselves trapped in alow-growth path because their lack of financial resources prevents them from

attaining optimal growth rates. The inflow of foreign capital can foster growth inthe host economy by easing the shortages of capital, foreign exchange and skills.The growth process can become self-sustained if backward and forward linkages

emerge from MNEs to the host economy and if FDI helps to raise the profitabilityof domestic investment. Additional benefits may accrue to the governmentthrough higher tax revenues.

Some economists point out, however, that FDI may harm the host economyby “crowding out” domestic investment and suppressing local entrepreneurship.

Concern has also been expressed over a possible deterioration in the balance ofpayments due to increased imports and profit repatriation, and over reduced taxrevenues as a result of transfer-pricing practices, tax allowances and other

financial incentives granted to foreign firms. Thus, although this conventionalanalytical model helps to assess the benefits of private capital flows, it does notsettle the question of what role FDI plays in development (see inter alia Reuber et

al., 1973, and Lall and Streeten, 1977).

More recently, following the impressive surge in FDI flows into several

developing and emerging economies, there has been renewed interest in empiricalanalysis of the FDI-growth nexus. Such interest has also been stimulated by newdevelopments in growth theory. The “endogenous growth” model identifies

knowledge accumulation as the driving force explaining the long-term growth ofthe economy (OECD, 2001a). FDI, which provides a channel for knowledgeacquisition and dissemination, can therefore act as an engine of growth for the

recipient economy. Furthermore, FDI tends to be less volatile than other capitalflows, thereby exerting durable positive effects on growth (see, for example, Lipsey,2000, and Reisen and Soto, 2001). Following this line of analytical work, this

chapter aims to shed some light on the growth impact of FDI by presentingeconomic arguments, discussing methodological problems and reviewing empiricalfindings available in the growth literature.

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3.1 Putting Theory to Work

According to endogenous growth models, the impact of FDI on growthdepends crucially upon the existence of production and knowledge externalities. In

the standard neo-classical model, production is represented by a technologyproviding constant returns to scale, relating the level of output to input bundles.FDI enters this model as an additional production input. More precisely, FDI is

treated as additional investment that increases the domestic capital stock. This isnot, however, the only channel through which FDI can affect growth. Industrialorganisation studies point to the peculiar nature of FDI, which is better described

as a “combination of capital stock, know-how and technology” (de Mello, 1997).

The central question in empirical analysis of the FDI-growth nexus is thus

whether FDI significantly affects the growth rate of income or factor productivity.One can address this question by using various econometric techniques. In theearly literature, for instance, many standard growth-accounting exercises were

conducted to break down the growth rate of aggregate output into the respectivecontributions from the growth of capital and labour inputs and from technologicalchange. These analyses, however, provide only a mechanical decomposition of

output growth into its various sources, without explaining how these changes areaffected by the “fundamentals” of the economy. Such limitations can be overcomeby estimating growth equations based on neo-classical production theory (see

Barro and Sala-i-Martin, 1995, Chapter 10).

Some further comments are in order concerning the theoretical formulation

of the FDI-growth nexus. First, one should analyse explicitly the extent to whichFDI may substitute for domestic investment. This question has been addressed byincluding domestic investment directly in the growth equations (Borensztein et al.,

1998) or by estimating investment equations that incorporate FDI (Agosin andMayer, 2000; McMillan, 1999). Second, since the long-term effects of FDI ongrowth depend on technological and knowledge externalities that spill over to

domestic firms in the host country, it is necessary to investigate whether theseexternalities indeed exist. Empirical studies addressing this question are moremicroeconomic in nature and will be discussed in Chapter Ⅴ; only a few attempts

have been made to take such spillover effects explicitly into account in themacroeconomic context (Bende-Nabende et al., 2000). Finally, as discussed inChapter Ⅱ, local conditions such as technological capabilities, human capital and

the development of domestic financial markets are likely to play an important rolein determining the location of FDI flows. It is thus necessary to examine

29

empirically whether any necessary pre-condition (or threshold) has to be met inthe host economy for the FDI-driven growth to materialise16.

In endogenous growth models, as was noted above, knowledge accumulationand diffusion play the key role. The existence of technological and knowledgeexternalities counterbalances the effects of diminishing returns to capital

accumulation and keeps the economy on a sustained long-term growth path. FDIcan make a substantial contribution to the increase in the host economy’s stock ofknowledge, not only by introducing new capital goods and production processes

(embodied technical change), but also by providing new managerial know-how andskills improvement that can spread to domestic firms (disembodied technicalchange). Skills may be upgraded through formal training or learning by doing

within foreign affiliates. By enhancing the local stock of knowledge, FDI willtherefore have both short-term and long-term impacts on the host economy andboost long-term growth (see Box 3.1 for a more technical discussion).

16 This argument is related to an extensive literature on threshold externalities (see Azariadis andDrazen, 1990), according to which the attainment of certain minimum critical thresholds in the hosteconomy is required to trigger the development process.

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Box 3.1. Short-term and Long-term Impacts of FDI on Growth

Endogenous growth theory challenges the conventional view of economic growth byproviding sound theoretical arguments for preventing the unbounded decline in themarginal productivity of capital. According to this theory, FDI can improve both short-termand long-term rates of growth in the host economy through knowledge and technologyspillovers from the R&D and job training activities of MNEs.

The growth impact of FDI can best be understood by considering a simple productionfunction, specified in equation (1). Y is domestic output, A denotes technology available at agiven time, L is the labour force and KH and KF are respectively the domestically owned andforeign-owned stock of capital.

( )LKKAFY FFHH θηη ,,= (1)

While A incorporates disembodied technical change, embodied technical change iscaptured by the factor-specific parameters ηH, ηF and θ. Note that, according to the standardassumptions of the model, each production input has a positive marginal productivity (F i > 0,i = K, L), but this productivity increases at a decreasing rate (Fii < 0).

Equation (1) provides a simple description of the twofold impact of FDI on domesticproduction. In the short run, output expands, as the foreign-owned stock of capitalincreases (FF> 0). In the long run, FDI exerts an indirect effect on Y through the changesinduced in the other inputs (ηH, ηF and θ) and in the technological parameter (A).

Here the question of whether FDI is substituting for or complementing domesticinvestment is of crucial importance to the effect of FDI on Y through KH. If foreigninvestment helps to increase the profitability of domestic capital in the recipient country,then both KH and output increase (FH F > 0). If, on the other hand, FDI crowds out domesticinvestment, KH decreases and so does output (FHF < 0). The net effect on output, therefore,will depend on the magnitude of FHF < 0 and FF > 0. Moreover, technological improvementthrough FDI is measured by changes in the A and η parameters, while skills improvementis reflected by changes in θ. An increase in these parameters induces an unambiguouspositive effect on output Y.

From the methodological point of view, however, the inclusion of FDI in neo-

classical growth equations poses two major problems. One is the problem ofreverse causality. GDP growth by itself or factors that affect GDP growth (such aswell-functioning institutions) may influence FDI as well. If causality runs from

growth to FDI, the use of ordinary least squares (OLS) estimation techniqueswould yield biased results. Instead of verifying whether FDI inflows foster GDPgrowth, the econometric analysis may have picked up how much the latter

influences the former. The second major problem is that of “spurious correlation”caused by omitted variables in growth equations. FDI is likely to be significantlycorrelated with other explanatory variables that are also expected to affect growth.

In this case, omitting some important variables from the right-hand side of thegrowth equation would result in biased estimation of the growth coefficient of FDI,since this coefficient is most likely to pick up the impact of these omitted variables.

As a corollary, one needs to know how and to what extent FDI interacts with other

31

explanatory variables. Many factors that are expected to exert a positive impacton growth, such as domestic capital formation and international trade, may bestimulated by FDI as well17. In order to disentangle the full effects of FDI on

growth, various spillover effects must therefore be specified and estimated in anappropriate manner18.

3.2　FDI and Growth: Empirical Evidence

This section reviews and discusses the main findings of 15 empirical studies

based on estimations of endogenous growth models. This literature review focuseson the four major questions that arise from the above discussion in themacroeconomic context: (1) Does FDI significantly affect the growth of income or

productivity? (2) Does FDI “crowd out” or “crowd in” domestic investment? (3) Dotechnology and knowledge spillovers occur in the domestic economy? (4) Are thereany necessary pre-conditions (e.g. human capital, technological or financial

market development) that must be met if these positive effects are to materialise?The results of this review are presented in Annex Table 3.1, with an indication ofwhich questions are addressed by individual studies. In this section, much of the

discussion will address questions (1) and (4), which are the focal point of existingempirical studies in the growth literature.

The vast majority of the studies reviewed here indicate that FDI does make apositive contribution to both income growth and factor productivity in hostcountries. Using panel data for 16 OECD countries and 17 (mostly Asian) non-

OECD countries over the 1970-90 period, de Mello (1999) find a positive andsignificant impact of FDI on output growth in both country groups, once country-specific characteristics are taken into account19. FDI tends to increase output

growth through higher productivity in OECD countries (technological leaders) andthrough capital accumulation in non-OECD countries (technological laggards). Ina similar vein, Xu (2000), using US survey data on manufacturing MNEs, finds

strong evidence of the positive effect of FDI on total factor productivity (TFP)

17 The question of FDI-trade linkages will be taken up in the next chapter.18 To address these methodological problems, researchers have taken various approaches, such asthe application of Granger causality tests and cointegration analysis to time-series data (e.g. deMello, 1999, and UNCTAD, 2000), the use of instrumental variable (IV) techniques to identify theautonomous impact of FDI on growth (e.g. Carkovic and Levine, 2000; Reisen and Soto, 2001; andLensink and Morrisey, 2001), and the construction and estimation of a full structural model basedon three-stage least squares (3SLS) or full-information maximum-likelihood methods (Bende-Nabende et al., 2000).19 Such characteristics are dealt with by introducing country-specific and group-specific dummiesand applying a standard fixed-effect estimation technique.

32

growth in recipient countries, but the technology-transfer effect is found to bestatistically significant only for developed countries. He argues that theabsorption of MNEs’ technology may require a certain level of human capital

accumulation on the recipient side and that many developing countries cannotmeet such a threshold condition.

Soto (2000) and Reisen and Soto (2001) investigate the growth impact ofshort- and long-term capital flows using a panel of 44 developing countries overthe 1986-97 period. After controlling for potential reverse causality, their

estimation results find a robust and positive correlation between FDI and portfolioequity flows on the one hand and GDP growth on the other. The superiority ofequity over debt flows in stimulating growth is also established for those

economies with underdeveloped banking systems. Since high volatility in capitalflows may wreak havoc on the economic performance of a developing country, theapparent lower volatility of FDI relative to other kinds of capital flows is another

possible growth-enhancing feature20.

In contrast, Carkovic and Levine (2001), whose panel data cover 72 countries

over the 1960-95 period, find no significant impact of FDI on growth. Theexogenous (i.e. independent of GDP or TFP growth) component of FDI exerts nosignificant positive impact on output growth, nor is it strongly linked to

productivity growth. The impact on capital accumulation is found to bestatistically significant and positive, but this relationship is not robust to differentspecifications of the regressions with respect to other determinants of capital

growth. Such discrepancies in estimation results may be explained at least in partby the choice of sample countries and periods. The panel data used by Reisen andSoto (2001) cover almost exclusively middle- and low-income countries over a

shorter period when significant changes in capital flows have taken place.

20 Although researchers hold divergent views as to the growth impact of volatility in capital flows,one point on which most economists agree is that shocks from short-term capital flows aretransmitted more quickly between countries than those arising from FDI and other long-term flows.As to the volatility of FDI in particular, Lensink and Morrisey (2001) argue that while suchvolatility is found to have a consistently negative effect on growth, this effect is actually due not tothe volatility of FDI per se, but to unobserved variables whose growth-retarding effects are capturedby FDI volatility. The swings in FDI might reflect political and economic uncertainty in the hostcountry, a factor that is widely acknowledged to hamper economic growth.

33

3.2.1　Threshold Externalities

The recent literature shows that developing countries need to have reached a

certain threshold level of development in terms of education or infrastructurebefore they can capture the benefits associated with FDI ( Saggi, 2000). A usefulsurvey by de Mello (1997) points to differences in the growth impact of FDI across

countries: since recipient countries’ technological capabilities are likely todetermine the scope for spillovers from foreign to domestic firms, the growthimpact of FDI tends to be limited in technologically less advanced countries.

Borensztein et al. (1998) address the technology-gap question by developinga growth model in which FDI contributes to technological progress through capital

deepening, i.e. through the introduction of new varieties of capital goods.Recognising that such beneficial effects are likely to depend on the skills of thedomestic labour force, they interact the FDI variable with a measure of human

capital development (secondary school attainment). The authors find that FDIcontributes to growth, though the magnitude of this effect depends on the stock ofhuman capital available in the host economy. In particular, they argue that FDI

raises growth only in those countries where the labour force has reached aminimum threshold of educational attainment. They also find that FDI tends to“crowd in” domestic investment, suggesting that the attraction of complementary

activities outweighs the displacement of domestic competitors21.

Similar results are obtained by Blomström et al. (1994). The authors find

that the positive impact of FDI on growth, though robust to different samplespecifications, vanishes when the sample is limited to lower-income developingcountries. They argue that FDI is a source of growth only for a country already at

a relatively high level of development and that low-income countries lack thecapabilities needed to absorb the FDI-related technology transfer. This issue isreviewed and discussed in further detail in Chapter Ⅴ.

3.2.2　Local Financial Markets

The development of domestic capital markets may be another requirement

for realising the potential benefits of FDI in the host country. The impact offinancial market development on growth has been widely studied theoretically

21 McMillan (1999) also argues that FDI can play a strong catalytic role for domestic investment indeveloping countries. According to Agosin and Mayer (2000), such a “crowding in” effect of FDI canbe found for Asian countries but not necessarily for other developing regions.

34

(among others, Acemoglu and Zilibotti, 1997) and empirically (Beck et al., 2000).Imperfect and underdeveloped financial markets are likely to penalise domesticfirms more than foreign affiliates of MNEs. Alfaro et al. (2001) develop a model in

which FDI induces higher growth by increasing output directly in the MNE sectorand indirectly, via spillovers, in the domestic sector. In this model, financialmarket constraints hinder the ability of domestic firms to invest and thus to

benefit from the spillover effects of FDI. This model was tested empirically byintroducing measures of both FDI inflows and financial market development, aswell as an interactive term encompassing the two, in the augmented growth

regression. The interactive term is found to have a positive and significant impacton GDP growth, while the coefficient of the FDI term is statistically significantbut has a negative sign22. The authors interpret these results as showing that

“there is a threshold level of the development of financial markets below whichFDI will not have any beneficial effect on growth” (ibid., p. 12)23.

Similarly, Hermes and Lensink (2000) argue that the development of therecipient economy’s financial system is an important pre-condition for any positiveimpact of FDI on economic growth. Many of the growth-enhancing effects of FDI

work through the adoption of new technologies and skills, which, in turn, dependupon the availability of financial resources. The existence of well-developedfinancial systems that mobilise savings efficiently and screen investment projects

is thus an important pre-condition for the FDI-growth nexus to materialise. Theempirical research conducted to date supports this claim: only in those countrieswith a sufficiently developed financial system (as measured by the ratio of private

sector bank loans to GDP) did FDI boost the growth of GDP per capita.

Finally, some comments on threshold externalities may be in order from the

standpoint of estimation techniques. First, recent developments in growthempirics using panel-data analysis have opened the door for more rigorous testingof the FDI-growth nexus (see Annex Table 3.1, “Estimation technique” column).

Panel-data estimation makes it possible not only to exploit both cross-section andtime-series variability of the data, but also to account for unobserved countryheterogeneity by introducing country-specific effects. The application of these

22 This result appears to be robust with respect to the use of different measures of financial marketdevelopment.23 Since both the volume of FDI and the efficiency of financial markets are likely to be higher infaster-growing economies, reverse causality could yield a biased result on the interactive term.However, instrumental variable estimation of the cross-country growth regression does confirmprevious findings, pointing to a positive and significant contribution of FDI to growth in countrieswhere financial markets are sufficiently developed.

35

techniques to dynamic models, however, may violate the statistical assumptionsthat ensure unbiased estimation. The dynamic nature of the data can introducecorrelation between the error term and the explanatory variables. This additional

source of endogeneity generates the risk of reverse causality discussed above.Arellano and Bond (1991) and Arellano and Bover (1995) have developed anappropriate instrumentation technique for dynamic panel data (DPD) that makes

it possible to control for the potential endogeneity of all explanatory variables,thereby yielding unbiased results.

Second, the use of country-specific effects in panel-data estimation permitsthe introduction of a certain degree of heterogeneity among the countries underconsideration, but this technique does not solve the heterogeneity problem. All

other estimated coefficients are in fact assumed to be equal across countries. Thisassumption of homogeneity is not problematic if the causal link can be supposedto operate in more or less the same way in all countries. Evidence from empirical

studies based on microeconomic data, however, points to firm-specificity inacquiring FDI-related spillovers (see Chapter Ⅴ for further discussion). Empiricalresults based on macroeconomic data, which are reviewed here, support this

microeconomic evidence, pointing to the existence of pre-conditions or thresholdsthat must be attained if recipient countries are to benefit from FDI. Theheterogeneity problem thus seems to be an important feature. Failing to

acknowledge this problem in the empirical estimation leads to serious bias andinconsistency. The interpretation of the result can be misleading, since imposinghomogeneity of coefficients implies that the causal relationship under

investigation either occurs everywhere or occurs nowhere in the panel (Usha Nairand Weinhold, 2001).

Two recent papers address this issue, applying heterogeneous panelestimation techniques (i.e. assuming that the slope coefficient can differ from onecountry to the next) to the FDI-growth relationship. De Mello (1999) finds

empirical evidence of the hypothesis of cross-country heterogeneity in the FDI-growth relationship by comparing the results of the fixed-effect estimator withthose of the mean group estimator. Separate regressions are estimated for each

country and the estimated coefficients are averaged for each group. While theassumption of homogeneity seems to be appropriate for OECD countries, it seemsclear that heterogeneity prevails among non-OECD countries, where the

aggregate parameter estimates differ from the average of individual countrycoefficients.

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Usha Nair and Weinhold (2001) apply a somewhat different technique to asample of 24 developing countries from 1971 to 1995. They begin by estimating adynamic panel model under the assumption of homogeneity, finding that the FDI

growth rate has a strong positive impact on GDP growth. They also useinteractive terms to check whether either the level of human capital or tradeopenness affects this relationship, finding no statistically significant impact for

the FDI-schooling term but a significant and negative impact for the FDI-openness term. This would mean that FDI has less impact on growth in more openeconomies. Heterogeneity is then introduced and the model re-estimated using a

mixed (fixed and random) effect model. The results confirm the existence of apositive impact of FDI on growth. Furthermore, the mean coefficient estimated forthe FDI-openness term is positive, though not statistically significant. These

findings support the claim that there is substantial cross-country variation in theway FDI interacts directly and indirectly (i.e. through its impact on other growthdeterminants such as human capital or openness) with growth.

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Annex Table 3.1. FDI and Growth: Literature Survey

Authors (year) Data/coverage Questionsaddressed

Estimation technique Major findings

Agosin and Mayer(2000)

UNCTAD. 32 developingcountries over the 1970-96period.

(2) Three investmentequations (one for eachregion) on pooled datausing SUR (seeminglyunrelated regression).

In Asia, there has been substantial crowding in of investment,while crowding out has been the norm in Latin America. InAfrica, FDI has increased overall investment one-to-one. Thepositive impacts of FDI on domestic investment are notassured.

Alfaro, Chanda,Kalemil-Ozcan andSayek (2001)

Net FDI inflows from IMF, IFS.Three samples (39-41 countries).Data averages over the 1981-97period.

(1), (4) Cross-country OLS(ordinary least squares)and IV (instrumentalvariables) regressions.

FDI contributes significantly to economic growth, but thepositive effects do not materialise unless local financialmarkets are sufficiently developed.

Bende-Nabende,Ford and Slater(2000)

WB data on FDI inflows as apercentage of GDP. Five ASEANcountries over the 1970-94period.

(1), (3) System of equationsestimated using 3SLS(three-stage leastsquares). A specificequation is estimated foreach endogenousdependent variable inthe growth regression(six channel equations).The model is estimatedseparately for each ofthe five countries.

FDI has a positive and significant coefficient in the growthequation for three out of five countries. The negative sign ofFDI in Singapore and Thailand is attributed to the specificcharacteristics of capital formation in these countries. Authorsclaim that FDI boosts growth in countries with a fair balance ofdomestic private capital and FDI. Furthermore, FDI is positivelyassociated with positive spillover effects that lead to humanresource development, transfer of technology, expansion oftrade and learning by doing. The spillover process is positivelyrelated to the level of economic development.

Blomström, Lipseyand Zejan (1994)

FDI inflows from IMF. 78developing countries over the1960-85 period.

(1) Granger causality. FDI Granger-causes economic growth.

Borensztein, deGregorio and Lee(1998)

Gross FDI outflows from OECDcountries. 69 countries, twoperiods: 1970-79 and 1980-89.

(1), (2), (4) Two-equation (one foreach decade) systemestimated using SURand IV.

FDI and growth: FDI exerts a positive effect on growth onlywhen a minimum level of human capital exists. FDI anddomestic investment: the complementarity between foreignand domestic investment is not robust to differentspecifications.

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Annex Table 3.1. FDI and Growth: Literature Survey (continued)



Carkovic and Levine(2001)

Gross FDI inflows from new WBdatabase and IMF. Period: 1960-95.

(1), (2), (4) Dynamic panel dataestimator (GMM).

The impact of the exogenous component of FDI on GDP growthis not significantly different from zero, nor is FDI strongly linkedto productivity (TFP) growth. These results are robust aftercontrolling for the level of human capital and financialdevelopment.

De Mello (1999) Net FDI inflows from IMF’sBalance of Payments Statistics.16 OECD and 17 non-OECDcountries over the 1970-90period.

(1), (4) Stationarity andcointegration analysisplus dynamic panelestimation (fixed-effectand mean groupestimators).

The FDI-growth nexus is not robust in all countries. Where thepositive relationship holds, it depends on country-specificfactors. FDI enhances output growth through higher productivityin OECD countries, and through capital accumulation in non-OECD countries. The growth impact of FDI tends to be lower intechnological leaders and higher in laggards.

Hermes and Lensink(2000)

WB data on FDI as a percentageof GDP. 67 least developedcountries, average of 1970-95data.

(1), (4) Cross-country OLSwith stability tests.

FDI enhance growth once a country has reached a giventhreshold of human capital and financial market development.For most developing countries (30 of 67, almost all countries insub-Saharan Africa), this threshold has yet to be attained.

Lensink andMorrissey (2001)

WB data on FDI/GDP over the1975-98 period in 115 countries.

(1) (4) OLS and IV for cross-section using the 1975-98 average values.Fixed-effect panelusing three ten-yearperiods.

FDI exerts a robust positive impact on growth. This result is notconditional on the level of human capital. Volatility of FDI has anegative impact on growth, but it probably captures the growth-retarding effects of unobserved variables such as politicaluncertainty.

McMillan (1999) IMF and UNCTAD. 1970-96. (2) Dynamic panel data oninvestment equations.

FDI is a strong catalyst for domestic investment in developingcountries. Lagged FDI has a stronger effect on private domesticinvestment than does lagged private domestic investment itself.

Reisen and Soto(2001)

WB data on net FDI inflows. 44non-OECD countries over the1986-97 period.

(1) Dynamic panel data. Different types of capital inflows have different impacts ongrowth. FDI and portfolio equity flows show a positive andsignificant correlation with growth; debt inflows show a negativecorrelation.

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Annex Table 3.1. FDI and Growth: Literature Survey (continued)



UNCTAD (2000) UNCTAD data on FDIinflows. Five-year periodsfrom 1970 to 1995 for morethan 100 LDCs.

(1) Granger causality andOLS

Results from analysis of time-series characteristics of theexplanatory variables show that: (1) FDI is always positivelyrelated to contemporaneous growth in per capita income;correlation with past growth rates is not robust; and (2) FDI is notrelated to past investment, while it is correlated with past trade.Growth regressions including lagged FDI and investment and othercontrols over individual and pooled periods have poor explanatorypower. Lagged FDI is found to exert a positive but not statisticallysignificant impact on growth. It turns out to be significant only wheninteracted with the level of schooling.

Usha Nair andWeinhold (2001)

WB data on net FDI inflowsas percentage of GDP for243 developing countriesover the 1971-95 period.

(1), (4) Non-dynamic fixed-effectpanel, first-differencedinstrumented panel andmixed (fixed and random)effect model(heterogeneous panel)

Standard fixed-effects estimation points to a significant andpositive impact of FDI growth on GDP growth. Results from thedynamic model under the assumption of heterogeneity reinforcethis claim and show how the indirect impact of FDI on growthworks differently across countries.

Xu (2000) Share of MNE affiliates’value added in host-countryGDP. 40 countries over the1966-94 period. Data fromthe US Direct InvestmentAbroad Benchmark Survey.

(1), (4) Instrumental variablespanel data estimation withcountry- and time-specificeffects.

FDI boosts total factor productivity growth. Strong evidence oftechnology diffusion from US affiliates to developed countries, butonly weak evidence for developing countries.

Zhang (2001) Inward FDI stock from WBand UNCTAD/TNC for 11Latin American and EastAsian countries. Period:1970-95.

(1), (4) Stationarity andcointegration.

FDI is found to promote growth in five out of 11 countries, four ofwhich are Asian. The impact of FDI on growth is country-specificand tends to be positive where policies favouring free trade andeducation are adopted to encourage export-oriented FDI.

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Chapter Ⅳ FDI-Trade Linkages

A long-standing debate among academic researchers in connection with therole of FDI in development concerns the linkages between FDI and trade. DoesFDI lead to trade, or does trade lead to FDI? Are FDI and trade substitutes or

complements? Given that global FDI flows have expanded much faster than worldmerchandise trade over the last three decades (see Chapter Ⅱ), these questionshave attracted considerable attention in the economics profession. Much of the

early literature of the 1970s and 1980s was directed to quantifying the home-country effects of FDI. This focus was partly motivated by concerns thatmultinational enterprises (MNEs) were replacing trade and “exporting” jobs from

home countries when they expanded overseas production24. Contrary to theprediction of the standard trade theory, however, most of the early studies basedon US and Swedish data found a positive association between outward FDI and

home-country exports (see below)25.

Such findings subsequently led to numerous empirical studies, many of

which are reviewed in Annex Table 4.1. Meanwhile, the environment forinternational business activities has changed dramatically. The combination ofrapid advances in information and communication technologies and improvements

in transportation service has made international transactions much easier,thereby stimulating outward FDI (mostly from developed countries) over the pastdecade. Since MNEs are significant players in world trade26, a major shift in the

mode of international transactions is likely to affect the volume and pattern ofinternational trade.

At the same time, many developing countries’ attitudes towards FDI aremore open and welcoming today than some ten years ago. This change reflectsgrowing recognition on the part of recipient countries that under the right

conditions FDI can play a critical role in the development process throughinternational transfer of capital, knowledge and technology. Indeed, an increasing

24 A recent study by Brainard and Riker (1997), based on US firm-level data for 1983-92, finds thatlabour employed by parent firms in the United States is substituted only at the margin by labouremployed by their foreign affiliates. Labour substitution is found to be far greater between foreignaffiliates located in host countries at similar levels of development.25 Owing to the limited availability of firm-level data, empirical analysis of FDI-trade linkages hasbeen restricted to several OECD countries, notably Japan, Sweden and the United States. Inaddition, the hypothesis is typically tested by relating affiliate sales in host countries to home-country exports to host countries.26 See Fukasaku and Kimura (2001) for further discussion.

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number of developing countries have embarked on both trade and investmentliberalisation, albeit to varying degrees, either unilaterally or in the context ofregional or multilateral initiatives. The experience of China and several Southeast

Asian countries since the early 1990s is a case in point. Empirical analysis of FDI-trade linkages has therefore attracted renewed interest in recent years amongpolicymakers and academic researchers in both developed and developing

countries.

Against the backdrop of these developments, this chapter presents a survey

of recent empirical studies that examine the relationship between FDI and trade.As a preliminary step, it briefly reviews what can be predicted from standardmodels of international trade and investment.

4.1　Standard Models

In its simplest form, the standard trade theory based on the so-called

Heckscher-Ohlin model offers a dramatic prediction about the relationshipbetween international capital movements and trade flows. It is shown that thesetwo flows are substitutes for each other (Mundell, 1957). In this model, cross-

country capital movements created by international factor-price differentials leadeventually to the elimination of international price differentials on factor marketsas well as on the goods market, generating an outcome that is identical to that of

a free-trade equilibrium with immobile factors between countries.

In contrast, the standard theory of the MNE conventionally regards exports

and FDI as alternative strategies for a profit-maximising firm. In a modelpresented by Caves (1996, Chapters 1 and 2), the MNE is defined as an enterprisethat controls and manages production plants located in (at least two) different

countries and maximises total revenues accruing from its intangible assets. Sucha firm supplies a foreign market either through production by an affiliate (or byanother firm in the host country under a licensing agreement) or through exports

from the home country27. He calls this model as the “intangible-assets model” ofthe horizontal MNE — a multi-plant firm producing the same line of goods fromplants located in different countries. The crux of this model is to explain the

existence of such an MNE from three perspectives: (1) it must possess some kindof intangible assets; (2) there must be locational forces that justify the dispersion

27 Caves (1996, pp. 3-7) attributes MNEs’ apparent preference for direct investment over licensing tothe problems of market failure associated with arm’s-length transactions in intangible assets.

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of plants in different countries; and (3) there must be some transactionaladvantage to placing these plants under common administrative control28.

This model was used extensively in the early literature to analyse whatdetermines the firm’s choice between exporting and FDI. It is shown, for instance,that any change in government policy that favours local production in the host

country (such as tariffs) discourages exports. Note, however, that this model isconcerned with a single-product firm whose market share in the host country istreated as a fixed amount. Accordingly, foreign production simply replaces direct

exports from the home country.

The question of FDI-trade linkages has also attracted considerable attention

in the international business literature, where the sequence and pattern ofcorporate internationalisation are analysed from both the historical and theindustrial organisation viewpoints. A recent survey article by UNCTAD (1996, pp.

75-93) emphasises that the dominant characteristic of internationalisation is theprecedence of exporting over outward FDI as a way of entering foreign markets. Ithas been argued that most firms, particularly those in manufacturing, tend to

build up overseas activities step by step: they typically start by exporting; then setup representative offices; establish marketing, distribution and after-salesfacilities; and finally build up local production facilities in some host countries29.

This linear sequence of development over time may be best explained by thetransactional approach to the MNE: the “successful firm runs out its successes inthe domestic market before incurring the transaction costs of going abroad”

(Caves, 1996, p. 12). Thus, the business literature again points to substitutionbetween FDI and trade as the dominant pattern of internationalisation30.

28 In a similar vein, Dunning (1977) proposes an eclectic approach which highlights three keyrequirements for a firm to undertake direct investment: (1) ownership advantage, (2) locationadvantage and (3) internalisation advantage. There is a fairly large body of literature on thedeterminants of FDI; for further discussion, see the survey articles on this topic by Aggarwal (1980),Lizondo (1990) and Petri and Plummer (1998).29 The same UNCTAD report points out that a similar step-by-step sequence can also be identified inmany natural resource–based industries, except that imports (not exports) induced by home-countrydemand precede FDI. In the case of service industries, this sequence may be “truncated” becausemany service companies often go abroad through FDI to support the foreign operations of customercompanies in their home countries.30 Horizontal FDI in response to actual or threatened import protection in host countries (“tariff-jumping FDI”) abounds in business history. In this case, however, the sequence ofinternationalisation runs from restrictive trade policy imposed by a host country to reduced exportsfrom a home country and then to foreign production through FDI (see below).

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In what follows, this chapter reviews 20 empirical studies conducted sincethe early 1980s that test statistically the relationship between FDI and exports31.As reported in Annex Table 4.1, some of these studies do find concrete examples of

substitution between foreign sales (of final goods) and home-country exports.Perhaps most noteworthy of all is a detailed study conducted by Blonigen (1999)at the product level. Blonigen’s empirical results for 21 specific products show

substitution of foreign affiliate production for home-country exports in most cases,and such substitutions are often large one-time shifts rather than gradualchanges over time.

As predicted by the standard theory of the MNE, trade policy can play animportant role in the firm’s decision on whether to export or invest abroad.

Belderbos and Sleuwaegen (1998) present an interesting case based on theexperience of Japanese electronics firms in the late 1980s. They find that asubstantial part of these firms’ FDI in Europe was induced by the EC’s anti-

dumping rules and other trade measures targeting Japanese firms — an exampleof the so-called “tariff-jumping FDI” that substitutes for exports from the homecountry. At the same time, sub-contractor firms supplying parts and components

to their parent firms in a vertical production (keiretsu) system are found to exportmore to Europe.

Another important case study is that conducted by Gopinath et al. (1999) onthe US food-processing industry. Following more closely the standard theory ofthe MNE, they develop a four-equation model in which foreign affiliate sales,

exports, employment and the demand for FDI are jointly determined. Theirregression results point to little substitution between foreign affiliate sales andexports: a 10 per cent rise in the price of exports leads to a 1.1 per cent drop in

foreign affiliates’ sales and a 0.6 per cent increase in exports. Moreover, a rise inagricultural protection in foreign countries tends to reduce US exports andincrease foreign sales by affiliates, though the net impact of protection is small.

Finally, a curious finding reported in this study is that the price of exports has avery small but positive effect on demand for FDI. They argue that such acomplementary relationship may be interpreted as suggesting that foreign sales

activities of MNEs include additional marketing and other support services.

31 See Hufbauer et al. (1994) for a survey of earlier studies dating back to the late 1960s.

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4.2　The Substitution-Complementarity Hypothesis Revisited

One major conclusion arising from this survey is that the empirical

relationship between FDI and trade is much more complex than what thestandard models of international trade and investment would predict. Themajority of the 20 studies reviewed in Annex Table 4.1 indicate a strong

complementary relationship between FDI and trade, despite differences in thedata sets and estimation techniques used. Such results are not necessarilysurprising, however, as the trade literature also indicates various possibilities

that the relationship between FDI and trade is more one of complementarity thanof substitution, once several restrictive assumptions imposed on the standardmodels are relaxed (see e.g. Markusen, 1983, and Wong, 1986). Three cases

deserve special attention.

First, foreign production may have important demand-enhancing effects in

host countries by creating local goodwill and customer loyalty (especially for brandnames), facilitating marketing and distribution (at lower costs and more reliabledelivery) and generating spillover effects on other export goods (for multi-product

firms). This is what Brainard (1997) calls the “proximity advantage” ofestablishing local production in host countries. Such “horizontal FDI” is thuslikely to increase overall demand, resulting in higher exports from the home

country (demand complementarity).

Second, if the production process is divided into upstream (parts and

components) and downstream (assembly) stages, and only the latter stage istransferred abroad, then the newly established assembly plant’s demand for partsand components can be met by exports from home-country suppliers. This is what

Lipsey and Weiss (1981, 1984) and other researchers describe as “vertical FDI”,whose aim is to exploit scale economies at different stages of production arisingfrom vertically integrated production relationships. This type of FDI is also likely

to increase exports (of parts and components) from the home country, partlyoffsetting the substitution of foreign production for exports of final products.

A recent study by Head and Ries (2001), using micro data on Japanesemanufacturing firms over the 1966-90 period, provides further evidence of theimportance of vertical FDI. It confirms that enterprises having a higher degree of

vertical integration show greater complementarity between manufacturing FDIand exports. Wholesaling FDI is also found to exert a statistically significantpositive effect on exports from the home country, which supports the earlier

findings reported by Yamawaki (1991). In contrast, separate regression analyses

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conducted only for assembly firms in the automobile and electronics sectors foundthat in this case, the relationship between manufacturing FDI and exports is oneof substitution.

Third, a production affiliate established in a host country may serve as anexport platform to third countries in a particular region, instead of simply meeting

local demand in the host country. The trade impact of such “export-oriented FDI”is clearly different from that of “market-oriented FDI”, though empirical researchremains very limited in this respect. A study by Svensson (1996), based on firm-

level data for 1974-90, finds that while the overall effect is trade-creating forSwedish MNEs operating in the European Union, affiliate exports tend to replaceexports from parent firms to other European countries. On the other hand, a

study by Kawai and Urata (1995) on Japanese manufacturing firms operating inEast Asia finds that FDI tends to generate “reverse imports” to the home country,as is postulated in Vernon’s (1968) product-cycle model32. Hufbauer et al. (1994)

report similar findings at the aggregate level where Japan is concerned.

More generally, the export-promoting effect of production by affiliates,

together with country-specific characteristics (such as skills and openness totrade and investment) and firm-specific characteristics (such as R&D), tends toincrease both parent-company exports and affiliate production. For instance,

Eaton and Tamura (1996) find that an increase in human capital has a significanteffect on both exports and FDI from Japan and the United States, while the“distance” variable tends to discourage exports more than FDI. Similarly,

Pfaffermayr (1996), working with panel data for seven Austrian industries,highlights the importance of R&D intensity as a common determinant of bothexports and FDI, though the latter effect is found to be statistically insignificant.

Overall, the export-promoting effect of FDI is likely to outweigh any tendency foraffiliate production to replace parent-company exports (Lipsey, Ramstetter andBlomström, 2000).

4.3　Aggregation, Causality and Endogeneity

A second major conclusion arising from this survey is that in addition to thepaucity of firm-level data, which are currently available only for a few OECDcountries, existing empirical studies face three methodological problems. One is

the aggregation problem. As Blonigen (1999) argues, it is certainly possible to find

32 See also Urata (2001).

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substitution between foreign sales and home-country exports for a given product33.This does not necessarily mean, however, that substitution dominates at theindustry level — a reasonable level of aggregation for policy discussion on matters

such as taxes and tariffs. If the aim of empirical research is to offer informeddiscussion about macroeconomic policy, a higher level of aggregation would bemore appropriate34. The problem of aggregation should thus be placed in a specific

policy context, subject to the availability of relevant data.

Second, although the choice of estimation technique is often dictated by the

availability of data, the use of cross-section analysis makes it difficult, if notimpossible, to address the problem of causality between FDI and trade.Alternative approaches are to use time-series or panel-data analysis. For example,

a pioneering study by Pfaffermayr (1994) applies Granger causality tests toquarterly data on Austria’s outward FDI and exports, finding a bi-directionalcausal link between the two. A more interesting result of this study is that a third

variable (real GDP of OECD countries) is found to have a significant impact onboth outward FDI and exports.

The problem of causality has been further investigated by de Mello andFukasaku (2000), who extend the time-series analysis to 16 selected LatinAmerican and Pacific Asian countries. In their regression results, the theoretical

prediction that imports precede inward FDI is supported by several countrycases, but the evidence is far from conclusive. As is expected from some previousstudies, they also find that net FDI flows have a negative impact on trade

balances in Pacific Asian countries over the full sample period (1970-94) and inLatin America over the reduced sample period (1970-84). In a similar vein,Wang et al. (2001) apply Granger causality tests to the case of China, the largest

recipient of FDI flows among non-OECD countries. In their study, causality seemsto run from China’s imports to FDI inflows and then to exports back to the homecountries.

In a different context, Pain and Wakelin (1998) have also addressed theproblem of causality by investigating whether the expansion of FDI has had any

significant impact on the trade performance of either home or host countries.Based on macroeconomic data for 11 major OECD countries, their regression

33 His study is based on US import data at the 10-digit level of the Harmonised System.34 Developing host countries often express concern over a potential deterioration in the balance ofpayments due to increased imports from and royalty payments to parent companies located indeveloped countries (WTO, 2001).

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results show that the trade effect of FDI varies both in sign and in magnitudeamong the OECD countries concerned. Their overall conclusion is that a smallnegative impact of outward FDI on home-country exports tends to be offset by a

corresponding positive impact of inward FDI on host-country exports.

A study by Goldberg and Klein (1997) indicates that exchange-rate

movements are an important determinant of both trade and FDI flows betweenJapan and several Southeast Asian countries. For instance, a real appreciation ofthe Japanese yen against the US dollar tends to induce Japanese FDI flows into

these countries, thereby contributing to the development of local export capacity,which supports the earlier findings of Kawai and Urata (1995).

The results of the time-series and panel-data analyses described above leadus to a third methodological problem, which is the question of endogeneity. Sincechanges in FDI are not exogenous, it is difficult to disentangle the effect of FDI on

exports from other factors that may have affected both FDI and exportssimultaneously. Amiti and Wakelin (2000) put it simply: “[T]he problem is morethan just one of endogeneity. There is also a conceptual issue: what does it mean

economically for the partial derivative of one endogenous variable to be positivelyor negatively related to another? The question is how does a shock to anexogenous variable affect the two endogenous variables [FDI and exports]?” (p. 3).

Conceptually, it is possible to distinguish between “substitutes” and“complements” in several ways. Most empirical studies reviewed so far (with the

notable exception of Gopinath et al., 1999) define this relationship, explicitly orimplicitly, in terms of volume . To test this hypothesis along the lines of thestandard demand theory, Clausing (2000) has tried to introduce the “price of

operating abroad” (e.g. tax rates and wage costs in host countries) as one of thekey explanatory variables on the right-hand side of US export equation. In otherwords, FDI and exports are likely to be substitutes when the estimated cross-price

elasticity of exports with respect to the cost of direct investment abroad is positive,and to be complements when this elasticity is negative. His estimation resultsshow a complementary relationship.

Similarly, Amiti and Wakelin (2000) have incorporated the “investment cost”index developed by the World Economic Forum (a qualitative index constructed on

the basis of country business surveys) into a standard gravity-trade model of USexports. They find that estimated cross-price elasticities of exports with respect to

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investment costs are negative but vary significantly among partner countries andover time35.

4.4　Towards a Unified Approach

Until recently, economic analysis of the MNE (including the determinants of

FDI) was regarded as a distinct area of research, based on partial equilibriummodels and largely separate from the general equilibrium analysis ofinternational trade. During the 1980s, the industrial organisation approach to

international trade opened a new frontier in the trade literature (the so-called“new” trade theory) by incorporating imperfect competition and scale economiesinto general equilibrium models. Yet, in the words of Markusen (2000, p. v), the

MNE was “generally missing, in spite of having precisely these characteristics”.

A new approach to the theory of the MNE has been developed over the past

several years, blurring the boundary between these two areas of research36. Thisapproach is now called the “knowledge-capital model” of the MNE, after theseminal work of Markusen et al. (1996) and Carr et al. (2000). This model allows

both horizontal and vertical FDI to arise endogenously, depending on countrycharacteristics (such as market size, income level, skill differentials and distance)and the level of trade costs (such as transportation costs and tariffs). Following

the “eclectic approach” developed by Dunning (1977), this model distinguishesbetween the knowledge-based service activity of the MNE as a source ofownership advantage (referred to as “headquarters services”) and the goods-

producing activity. This distinction leads to the possibility that these twoactivities can be geographically separated while remaining within a single firm. Itis also assumed that headquarters services serve collectively as an input in goods

production and are more skill-intensive than production.

This model shows that horizontal FDI will substitute for exports, depending

on the multi-plant scale economies realised relative to trade costs. In contrast,vertical FDI will complement exports, since the home country suppliesheadquarters services and/or intermediate products to the host country.

Ultimately, it is country characteristics and trade costs (net of trade and othergovernment policies) that determine which type of FDI will dominate. Thus, theknowledge-capital model of the MNE can provide a unified approach to

35 Note that their empirical study explicitly distinguishes the cost of direct investment from the costof international trade (e.g. tariffs and non-tariff barriers).36 Two articles by Markusen (1995 and 2000) provide an excellent overview of this topic.

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international trade and production with testable hypotheses, and a third majorconclusion that can be drawn from this survey is that empirical analysis of FDI-trade linkages has entered a new era, as exemplified by the recent work of Amiti

and Wakelin (2000) and Clausing (2000).

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Annex Table 4.1. FDI-Trade Linkages: Literature Survey

Authors (year) Data/coverage Estimation technique Major findingsLipsey and Weiss(1981)

14 manufacturing industries based onBEA survey data on US MNEs for1970.

Cross-section, OLS regression estimation ofa gravity trade model for exports of UnitedStates and 13 other countries, including netsales or net local sales of US MNEs as anexplanatory variable.

Overseas production by US affiliates tends toincrease US exports (complementarity effect).Its impact on exports from 13 foreign counties isgenerally negative.Estimated coefficients are higher for metals andmachinery than other industries.

Lipsey and Weiss(1984)

The same as for Lipsey and Weiss(1981).

Cross-section, OLS regression estimation ofparent company exports equations based ona gravity-type model, including net sales ornet local sales of US manufacturing affiliatesand sales of US non-manufacturingaffiliates.

Foreign production by a US firm does not onbalance substitute for exports by that firm to thearea where foreign production takes place.This complementarity effect is particularly strongfor intermediate products.

Blomström, Lipsey andKulchycky (1988)

7 manufacturing groups based on IUI(Stockholm) survey data on SwedishMNEs for 1970 and 1978.30 manufacturing industries based onBEA survey data on US MNEs for1982.

Cross-section, OLS and 2SLS (two-stageleast squares) regression estimation of agravity-type model for Swedish exports,including net sales or net local sales ofSwedish MNEs as an explanatory variable.Cross-section, OLS regression estimation ofa gravity-type model for US exports,including net sales or net local sales of USmajority- and minority-owned affiliates asexplanatory variables.

No evidence that host-country productionsubstitutes for exports from Sweden.The higher initial level of foreign production(1970) leads to a larger increase in Swedishexports between 1970 and 1978, with only oneexception (metal manufacturing).Predominance of positive relationships betweenaffiliates’ net sales and US exports, with a fewexceptions in which substitution effects are found.

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Annex Table 4.1. FDI-Trade Linkages: Literature Survey (continued)

Authors (year) Data/coverage Estimation technique Major findingsPfaffermayr (1994) Quarterly data on Austria’s outward FDI

flows, exports of goods and real OECDGDP during the 1969-91 period.

Time-series analysis of the causalrelationship between FDI and exportsbased on Granger causality andcointegration tests.

Granger causality tests indicate a bi-directionalcausal link between FDI and exports.Real OECD GDP (exogenous) has a significantimpact on both FDI and exports.

Hufbauer, Lakdawallaand Malani (1994)

Cross-section data on FDI (stocks andflows) and trade (exports and imports) for1980, 1985 and 1990 for Germany,Japan and the United States.

Regression estimation of standardgravity-type FDI and trade equations; inthe latter, lagged FDI is included on theright-hand side of the equation.

A given amount of outward FDI from Japan generatesabout twice as many Japanese imports as exports.This is not the case in the United States andGermany (except for 1980).

Kawai and Urata(1995)

Pooled sample data on Japanesebilateral trade with and FDI outflows to 48countries over the 1980-92 period foreight manufacturing industries.

OLS regression estimation of standardgravity-type trade and FDI equations,with lagged FDI or trade variables,respectively, included on the right-handside.

Two-way complementary interactions were found toexist between Japan’s FDI outflows and exports,except for some industries.FDI tends to increase imports more than exports.

Eaton and Tamura(1996)

Panel data on Japanese and US exportsand outward FDI to 72 host countriesover the 1985-90 period.

Tobit regression estimation of exportand FDI decisions based on a modifiedgravity model, including severalcharacteristics of destination countries.

Increases in human capital have a significant effecton both exports and FDI from Japan and the UnitedStates.Distance tends to reduce exports more than FDI.

Pfaffermayr (1996) Panel data on exports and outward FDIfor seven Austrian industries over the1980-94 period.

Logit-transformation regressionestimation of export and FDI equations,with factor intensities as commondeterminants.

A significant and stable complementary relationshipwas found to exist between exports and outward FDIwith bi-directional causality.R&D intensity tends to affect both FDI and exportspositively, though the coefficient is statisticallysignificant only in the latter case.

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Authors (year) Data/coverage Estimation technique Major findingsSvensson (1996) Pooled cross-section data of Swedish

MNEs (at the firm level) over the 1974-90period.

A variant of 2SLS regression estimation (theTobit method) with limited dependentvariables to take into account the possibilityof simultaneity in the relationship betweenFDI and exports.

Increased foreign production by affiliatestends to replace exports from their parentfirms and to complement parent firms’ exportsof intermediate products. The net effect ofthese can be negative, though quantitativelysmall.At the same time, exports from foreignaffiliates tend to create a strong substitutioneffect in third countries (i.e. replacing parentcompany exports), though the overall effect istrade-creating for Swedish multinationaloperations in the EC.

Goldberg and Klein(1997)

Panel data on trade and FDI flowsbetween two home countries (Japan andthe United States) and seven hostcountries (Argentina, Brazil, Chile,Indonesia, Malaysia, the Philippines andThailand) over the 1978-93 (or 94)period.

Panel-data regression estimation of tradeand FDI equations with fixed country effectsbased on a gravity-type model, including realbilateral exchange rates as explanatoryvariables.

Appreciation of the yen-dollar real exchangerate tends significantly to raise Japanese FDIinto Southeast Asia, but not into LatinAmerica.US FDI tends to substitute for US trade withSoutheast Asia, while Japanese FDI leads tomore outward-oriented local production in thearea.

Pain and Wakelin (1998) Semi-annual panel data on manufacturedexports and outward and inward FDIstocks for 11 OECD countries over the1971-92 period.

Panel-data regression estimation of dynamicexport demand equations.

The trade effects of FDI vary in both sign andmagnitude among the OECD countries understudy.Overall, a small negative impact of outwardFDI on home-country export performance isoffset by a corresponding positive impact frominward FDI on host-country exportperformance.

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Authors (year) Data/coverage Estimation technique Major findingsBelderbos andSleuwaegen (1998)

Firm-level data for Japanesemanufacturing firms producing 35electronics products.

Logit model regression analysis of Japanesefirms’ decision to undertake direct investment inthe EC, using the latter’s trade policy variables.Logit model regression analysis of Japanesefirms’ export intensity to Europe.

Tariff-jumping FDI by Japanese firms tends tosubstitute for their exports.Affiliated exporters tend to expand the supply ofcomponents to EC assembly plants operated bytheir core firms.

Blonigen (1999) 21 products (10 automobile parts for1978-91 and 11 final consumerproducts over the 1972-94 period).NBER trade data on US imports ofJapanese products and firm-leveldata on Japanese local production inthe United States.

Time series, seemingly unrelated regressionestimation of US import demand functions forJapanese products.

Product-level data allows separate identificationof both substitution (of local production forexports) and complementarity effects (fromvertical production relationships between finalproducts and intermediate inputs).Substitution of foreign production for exports oftenoccurs in large one-time shifts.

Gopinath, Pick andVasavada (1999)

Panel data on US foreign sales,exports, affiliate employment and FDIflows with ten host countries over the1982-94 period.

Panel-data regression estimation of a four-equation system in which four variables arejointly determined.

Foreign affiliate sales are found to substitute forexports at the aggregate food-processing level.Agricultural protection in foreign countries hurtsUS exports, while encouraging affiliateproduction.The price of exports has a very small but positiveeffect on FDI.

Amiti and Wakelin(2000)

Panel data on US bilateral trade flows(non-agricultural goods) with 35partner countries over the 1986-94period.

Panel-data regression estimation of US bilateraltrade flows with fixed country effects based on agravity-type model, including two indicesrepresenting trade and investment costs asexplanatory variables.

Estimated cross-price elasticities of exports withrespect to investment costs are negative but varysignificantly across countries and over time.Overall, a fall in investment costs in a hostcountry tends to increase US exports to thatcountry.

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Authors (year) Data/coverage Estimation technique Major findingsClausing (2000) Two panel data sets constructed from BEA

surveys for the 1977-94 period: one on theoperations of US parent firms in 29 hostcountries and the other on the USoperations of foreign affiliates of firmsbased in 29 home countries.

Panel-data regression estimation of USexport and import equations with or withoutfixed country effects based on a gravity-type model, including net local sales as anexplanatory variable.Separate regression estimation of USexport equations, incorporating the “price”of operating abroad (e.g. taxes paid to hostcountries) among the explanatoryvariables.

Complementarity between net local sales andtrade is far greater for intra-firm trade thaninter-firm trade.As the price of operating abroad increases,exports fall, which suggests that foreignproduction and exports are complements.

De Mello and Fukasaku(2000)

Annual data on total imports, manufacturedexports and net FDI inflows for 16 selectedLatin American and Pacific Asian countriesover the 1970-94 period.

Time-series analysis of temporal causalitybetween trade and FDI flows over bothshort and long terms, based on Grangercausality and cointegration tests.

The theoretical claim that imports precedeinward FDI is supported by several countrycases, but the evidence is far fromconclusive.The prevailing impact of FDI on the tradebalance is negative in Pacific Asia over thefull sample period and in Latin America overthe reduced sample period (1970-84).

Lipsey, Ramstetter andBlomström (2000)

Ten manufacturing industries based onMITI survey data on Japanese MNEs for1986, 1989 and 1992.

Cross-section, regression estimation ofJapanese parent exports based on agravity-type model.

Increased production in a region by a parentfirm’s affiliates is associated with greaterexports to the region from the parent firm.The more the firm produces abroad, thehigher Japanese parent companyemployment tends to be for a given level ofparent production.

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Authors (year) Data/coverage Estimation technique Major findingsHead and Ries (2001) Panel data for 932 Japanese manufacturing

firms over the 1966-90 period.Explicit distinction between manufacturingand distribution affiliates set up byJapanese MNEs.Explicit distinction between majorassemblers and their parts suppliers.

Panel data regression estimation ofJapanese manufacturing firms’ exportfunctions with or without fixed effects,including time-varying firm characteristicsamong the explanatory variables.Separate regressions estimated for tenautomobile firms and nine electronics firms(assemblers in both cases) and for 96 partssuppliers to these two groups.

Firms that are more vertically integrated showa greater degree of complementarity betweenmanufacturing FDI and exports.The coefficients of wholesale FDI on exportsare found to be positive and statisticallysignificant.For these two groups of assemblers,manufacturing FDI and exports exhibit asubstitution relationship.The manufacturing investment of assemblershas a positive and significant effect onexports by suppliers of automobile parts.

Wang et al. (2001) Panel data on China’s exports, imports andinward FDI stocks (in real terms) withrespect to 19 home countries/regions overthe 1984-98 period.

Granger causality tests based on a standardVAR (vector autoregression) model.

Causality is found to run from China’s importsto FDI inflows and then to its exports back tothe home countries.Two-way complementary relationshipsbetween China’s exports and imports.

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Chapter Ⅴ FDI and Technology Transfer

Technology transfer through FDI is another topic of long-standing interest to

academic researchers in the development field. Multinational enterprises (MNEs)are among the most important players in the world in terms of generating andcontrolling new technology37, and they derive much of their profits from putting

the tangible and intangible resources available in different countries to the mostproductive use. As part of these global profit-making operations, FDI inherentlyinvolves the transfer of capital, technology and know-how from home to host

economies (see Figure 1.1). This “packaging” of better technologies with thecapital and skills needed to exploit them offers developing countries theopportunity to increase productivity and hence, in the long run, economic growth

and development. While FDI is only one of several channels for internationaltransfer of technology, many countries view it as the most important means ofacquiring better technologies to upgrade their own production bases (see Box 5.1).

Nonetheless, it is difficult to paint an unambiguous picture as to how MNEstransfer technology through FDI and how this technology contributes toproductivity growth in the host economy38.

This difficulty stems from the very nature of technology transfer throughFDI. As discussed in Chapter Ⅲ, knowledge accumulation and dissemination are

key to the long-term growth of the host economy. According to endogenous growthmodels, FDI can exert a positive impact on domestic output through its effect onthe overall level of technology (disembodied technical change), through

technological improvements in the capital stock and through skills improvementsin the labour force. As such “spillover” effects are hard to quantify individually,most existing empirical studies have been directed to examining how significantly

FDI affects total factor productivity (TFP) growth.

37 The generation of new technology is highly concentrated in a handful of advanced industrialcountries and takes place mainly in large firms, typically MNEs. For example, G7 countries as awhole account for 90 per cent of world R&D expenditures, and the United States alone for40 per cent. In the United States, just 50 leading firms accounted for nearly 50 per cent ofindustrial-based R&D expenditures in 1996 (UNCTAD, 1999, p. 199).38 In this chapter, the term “technology” is used in a broad sense to signify the knowledge that isembodied in products, processes and practices, the latter including managerial skills and know-how.

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Box 5.1. FDI as a Mode of Technology Transfer

While FDI is only one of several means available for a firm to transfer technologyoutside its home country (e.g. exporting products that embody the technology or licensingits technology to an agent abroad), for developing countries it remains the mostimportant means of acquiring new technology. Technology transfer through FDI offersbenefits that other modes of transfer do not, for at least three reasons:

− Unlike trade in goods, where host countries must try to imitate and learn fromreverse engineering, FDI involves the explicit transfer of technology. In addition tothe technology itself, FDI brings needed complementary resources such asmanagement experience and entrepreneurial abilities, which can be transferredthrough training programmes and learning by doing. A World Bank study using firm-level survey data on Czech enterprises of different ownership shows that domesticfirms receiving FDI or involved in joint ventures tend to provide trainingprogrammes and acquire new technologies more frequently than those with noforeign partners (Djankov and Hoekman, 1999).

− Technologies used by foreign affiliates are not always available in the arm’s-lengthmarket, and even when they are available, some technologies may be more valuableor less costly when applied by MNEs that developed them, rather than by outsiders.This is especially the case when local employees need to develop specific skills inusing the technology. MNEs also offer brand names and access to regional and globalmarkets.

− The entry of foreign affiliates in local markets provides an incentive for domesticfirms to innovate in order to protect their market shares and profits. This“demonstration effect” alone is likely to lead to productivity increases in local firms(see the discussion below, under “Horizontal Linkages”).

The process of technology transfer to local firms may take longer than hostgovernments would normally expect from foreign partners, particularly in technologicallyadvanced sectors. A recent survey of 20 leading EU companies with investments inChina, conducted by a group of business economists, finds that these companies show ameasure of reluctance to transfer their core technologies and to base R&D activitiesthere. One reason for this reluctance is the insufficient legal protection of intellectualproperty rights in the host country (Bennett et al., 2001). More generally, thecharacteristics of the host country and its domestic absorptive capacity are keydeterminants of international technology transfer (Radosevic, 1999).

A key question to be addressed in this chapter is how and the extent to whichthe productivity growth of local firms is influenced by the presence of MNE

affiliates. Technology transfer is not instantaneous; it takes place over time, oftenyears rather than months. As a result, empirical work on this topic would requiredetailed microeconomic data on the production performance of individual firms or

plants of different ownership (local, foreign or joint venture), and the coveragewould have to extend across industries and over several years in order to observeboth intra-industry and inter-industry linkages and spillovers (Kugler 2000). It

would indeed be a daunting task to meet such extreme data requirements. As nocomprehensive analysis of this character has ever been made, one normally has to

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look for circumstantial evidence of technology transfer through FDI on the basis ofdetailed case studies (Blomström and Kokko, 1996).

Bearing in mind these methodological and data limitations, this chapterpresents a review of recent empirical literature on the relationship between FDIand technology transfer in the development context. It begins by describing

various mechanisms that may be at work when technology is transferred throughFDI and goes on to discuss the main results of existing empirical studies based onmicroeconomic data (see also Annex Table 5.1).

5.1　Mechanisms of Technology Transfer

As noted above, it is widely recognised that FDI provides an important

channel for international transfer of technology. This does not, however, explainexactly how this transfer and the resulting spillovers take place. The literaturesuggests that FDI transfers technology to the host economy, either directly or

indirectly, via four mechanisms:

• Vertical linkages: MNE affiliates may transfer technologies to local firms that

supply them with intermediate goods, or to buyers of their own products.• Horizontal linkages: Local firms in the same industry or phase of the

production process may adopt technologies through imitation, or may be forced

to upgrade their own technologies due to increased competition from MNEaffiliates.

• Labour turnover: Workers trained or previously employed by MNE affiliates

may transfer their knowledge to other local firms when they switch employersor set up their own businesses.

• International technology spillovers: MNEs may enhance local technological

capability through R&D activities in the host country or through intra-firmtransfer of technology (i.e. from the parent firm to its foreign affiliates).

In the following sub-sections, we discuss each of these four channels in moredetail.

5.1.1　Vertical Linkages with Suppliers and Buyers

It has long been recognised that MNEs can benefit the host economy via thebackward and forward linkages they generate. Backward linkages are relations

with local suppliers, while forward linkages refer to relations with buyers —either consumers or firms that use intermediate and capital goods (including

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machinery) produced by MNE affiliates. While the formation of inter-firmlinkages does not inherently ensure that technology is actually transferred or spiltover to local firms, such linkages can be an important channel for technological

spillovers, except in a self-contained “enclave” situation. Moreover, it is unlikelythat MNEs will be able to appropriate the full value of these explicit and implicittransfers to their host-country business partners (Blomström et al., 1999).

Some theoretical and empirical works have studied the factors that promotevertical linkages. It seems, first, that the larger the host market and the greater

the technological capabilities of local suppliers, the more pronounced are thelinkages. Second, according to the model developed by Rodríguez-Clare (1996),more linkages are created when the production process of the MNEs uses

intermediate goods intensively; when the costs of communication betweenheadquarters and the affiliate production plant are large; and when the home andhost countries are not too different in terms of the variety of intermediate goods

produced. Third, government policies can also promote linkage creation, e.g.through policies requiring a minimum of local content, although the efficiency andusefulness of such policy requirements have been debated in the literature39.

Whether MNE affiliates in host countries actually form such verticallinkages largely depends, however, on affiliates’ decisions on how to source inputs

(Chen, 1996). Although in some cases local content starts at a very low level, ingeneral local vertical linkages are extended over time, which could be aconsequence of technology transfer. Studies of the Asian electronics industry have

generally shown that linkage creation was negligible at first, but had grownsubstantially five years later (Rasiah, 1994). When addressing the impact oflinkage creation, it should be borne in mind that MNEs improve welfare only if

they generate linkages beyond those already generated by the local firms theydisplace.

MNEs can provide raw materials and intermediate goods, or assist localsuppliers in purchasing these inputs, as well as helping prospective suppliers toset up production facilities. They can also provide training in management and

organisation, and help suppliers to diversify by finding additional customers.Empirical evidence of such backward linkages is found in many studies in theearly literature, including Lall’s (1980) study on Indian truck manufacturers,

39 See UNCTAD (2001, Chapter V) for further discussion.

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Wanatabe (1983), UNCTC (1981) and Behrman and Wallender (1976). Many morerecent examples of such linkages can be found in UNCTAD (2001, Chapter IV).

Forward linkages, in contrast, are formed with local buyers. These may beeither distributors, which can benefit from the marketing and other knowledge ofMNEs, or — in the case of intermediate products — downstream firms which can

use higher-quality and/or lower-priced intermediate goods in their own productionprocesses. Downstream firms may also benefit from lower prices arising fromincreased competition in their supply market (Pack and Saggi, 1999), and

consumers as well may benefit from lower-priced final products.

5.1.2 　Horizontal Linkages through Demonstration and Competition

The diffusion of technology through horizontal linkages (i.e. to competitors ofthe MNE affiliate in the host country) works through either demonstration or

competition effects40. The term “demonstration effect” refers to the fact thatexposure to the superior technology of the MNE may lead local firms to upgradetheir own production methods (Saggi, 2000). When an MNE starts using a specific

technology that has not previously been used in the host economy, its competitorsmay start imitating the technology. Often, the introduction of a new technology byan MNE reduces the (subjective) risk for local firms of using the same technology.

Local firms may lack the capacity, financial resources or information required toacquire the necessary knowledge or to adapt the technology to local circumstances.However, when a certain technology used by MNE affiliates proves successful in

the local environment, it may be adopted more widely by local firms.

While FDI may expand the range of technologies available to local firms, it

also usually increases competition in the local market. Moreover, demonstrationand competition effects reinforce each other. The entry of an MNE affiliateincreases competition, which is in itself an incentive to upgrade local technologies.

This further stimulates competition, which in turn causes an even faster rate ofadaptation of new technologies. Wang and Blomström (1992) also stress that themore competition the MNE affiliate faces from domestic firms, the more

technology it has to bring in to retain its competitive advantage, and hence thelarger will be the potential for spillovers.

40 Saggi (2000) argues that a strict definition of spillovers would count only the demonstration effect,because innovation in domestic industry induced by increased competition cannot be seen as pureexternalities but as a “benefit enjoyed by the host country that works its way through the pricemechanism” (ibid., p. 18). In practice, however, such a distinction is very difficult to make.

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The effects of increased competition are usually seen as beneficial. Increasedcompetition encourages both productive efficiency and more efficient allocation ofresources. This may be especially true when MNEs enter industries where high

entry barriers limit the degree of domestic competition (e.g. utilities). Case studiesindicate, however, that substantial improvements in productivity are obtained notso much through better resource allocation as through a reduction in slack or X-

inefficiency (WTO, 1998). This is the case when efficiency increases result fromlocal firms enforcing stricter or more cost-conscious management and motivatingemployees to work harder, instead of imitating technology.

In theory, competition generally improves efficiency and welfare, but entryby MNE affiliates does not necessarily increase competition. In fact, it may lead to

increased concentration. Economies of scale are an important determinant ofindustrial structure, and when a foreign affiliate enters a relatively small nationalindustry and increases the average firm size, this may initially improve resource

allocation. There are concerns, however, that strong MNE affiliates may out-compete local firms, or at least force them to merge, and the consequent increasein industrial concentration can result in market power. The abuse of market

power by the MNE (and possibly local firms) would then reduce allocativeefficiency.

Empirical evidence of demonstration and competition effects is difficult toobtain. Both effects are most likely to occur at the industry level (Saggi, 2000).One method of checking whether local efforts to adopt new technologies are

encouraged by FDI is to relate R&D expenditures by industry to foreign presence,but these expenditures must be controlled for the effect of FDI on marketstructure, which is very difficult. Still, some general studies address the issue of

horizontal linkages. Blomström et al. (1999), comparing foreign-owned anddomestically owned firms, find that new technology is frequently introducedsooner by foreign-owned affiliates and that competition spurs quicker adoption of

innovations by both types of firms.

On the basis of plant-level data for Venezuela, Aitken and Harrison (1999)

find a positive relationship between foreign equity participation and plantperformance, which implies that foreign participation does benefit the plants thatreceive it. However, this effect is found to be robust only for small plants with

fewer than 50 employees. For larger plants, foreign participation brings nosignificant improvement in productivity relative to domestic plants with noforeign participation. In general, productivity in domestic plants with no foreign

participation declines as foreign investments in other plants increase. This may

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result from a crowding-out effect: foreign competition may have forced domesticfirms to lower output, thereby forgoing economies of scale. On balance, however,the results show that the effect of FDI on the productivity of the entire industry is

weak but positive.

Djankov and Hoekman (1999) also find that FDI has a positive impact on the

TFP growth of recipient firms in the Czech Republic, but joint ventures and FDIappear to have a negative spillover effect on domestic firms that have no foreignpartners. Such findings need not imply, however, that host countries have nothing

to gain from FDI. Positive impacts such as improved resource allocation take time.When foreign firms bring in more efficient production methods, it is not surprisingthat some local firms suffer in the short run.

5.1.3　Labour Turnover

Labour turnover is another channel through which technology may betransferred and disseminated in a host country. Workers employed by the MNEaffiliate acquire knowledge of its superior technology and management practices.

When these workers switch employers or start up their own businesses, theyspread the technology. MNE affiliates usually try to avoid this kind of spillover bypaying an “efficiency wage” with a premium to keep employees from switching

jobs to domestic competitors (Globerman et al., 1994). If disclosing secrets to localmanagers would create unacceptable risks, e.g. due to managers’ tendency to takejobs with competitors, the MNE may consider using expatriate managers rather

than local ones.

The effects of labour turnover are difficult to establish. Several studies have

been undertaken that may provide some insights, although they show quitedifferent results. Katz (1987) finds that many managers of local firms in LatinAmerica were trained in the MNE affiliates where they started their careers. In a

study of 72 top and middle managers in Kenya, Gershenberg (1987) shows thatMNEs offered more training to their managers than did local private firms, but healso finds evidence that only a small percentage (16 per cent) of job changes

involved movement from multinationals to domestic firms. In the case of Mexico,Venezuela and the United States, Aitken et al. (1996) show that higher levels ofFDI were associated with higher wages in all three countries. In the first two,

they also find that multinationals paid higher wages than local firms butuncovered no evidence of wage increases by local firms.

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In a detailed study of the development of the Korean electronics industry,Bloom (1992) finds that substantial technology transfer occurred in the 1970swhen production managers switched to local firms. Pack and Saggi (1997) finds

similar results for Chinese Taipei in the mid-1980s: among employees of MNEaffiliates who changed jobs, almost 50 per cent of all engineers and 63 per cent ofall skilled workers joined local firms41. UNCTAD (1999) examines the experience

of Desh, a Bangladeshi garment firm which the Korean conglomerate Daewoosupplied with technology and credit. The study found that, over time, no fewerthan 115 of the 130 initial workers left Desh to set up their own firms or to join

newly established local garment firms.

5.1.4　International Technology Spillovers

Multinational firms are among the world’s foremost creators of knowledgeand technology. Of the top 25 R&D players world-wide, the first five positions are

held by governments (in descending order, the United States, Japan, Germany,France and the United Kingdom), but the next 20 positions are dominated byMNEs (Van Tulder et al., 2001). Many of these firms concentrate their R&D

activities in their home countries or other developed countries. Developingcountries account for only an estimated 6 per cent of global R&D expenditures(Freeman and Hagedoorn, 1992). Moreover, such expenditures are highly

concentrated even among developing countries: according to UNCTAD (1999)estimates using US firms as a proxy, the top four developing economies (Brazil,Chinese Taipei, Mexico and Singapore) account for 77 per cent of total R&D

expenditures in developing countries.

The rationale for this concentration lies in the need for efficient supervision

and scale economies in the R&D process itself42. In addition, concentration of R&Doffers a major advantage — from the firm’s perspective — in the form of“agglomeration economies”. This means that it is more efficient to cluster specific

R&D expertise in a certain region, using local research institutions and otherorganisations to form an “innovation system”. This kind of locational advantage isfairly durable over time, so that MNEs tend to keep most of their R&D centralised

at their headquarters (Globerman, 1979). Many developing countries do not offerthe infrastructure and institutions needed for fruitful interaction between

41 See also Natarajan and Miang (1992) for the case of Singapore. The authors argue that thetransfer of technology through the establishment of new local enterprises by those engineers andtechnicians who used to work for MNE affiliates has played an important role in building up a poolof indigenous supporting industries in Singapore.42 See Caves (1996, Chapter 7) for further discussion.

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academia, government and industry43. Another reason is the lack of protection ofproperty rights, including intellectual assets, in host countries. In a recent studyof EU-based companies regarding technology transfer to China, Bennett et al.

(2001) highlight weak protection of intellectual property rights as a main obstacleto building or expanding the R&D base of these companies in the host country.

Saggi (2000, p. 17), referring to UNCTAD data on trade in technology, pointsout that in 1995 over 80 per cent of global royalty payments — the explicit sale oftechnology — were made within the ambit of MNEs (i.e. from foreign subsidiaries

to their parent firms). In addition, FDI may contribute directly to the generationof knowledge in developing countries through the internationalisation of MNEs’R&D activities. Thus, a major policy concern for many developing countries is the

extent to which technology is transferred from the parent firm to its foreignaffiliates. Some argue that where R&D has been transferred to foreignsubsidiaries, the primary purpose has been to carry out adaptive tasks, drawing

on a few local resources in order to better serve the local market (Correa, 1999).MNEs are often blamed for failing to adopt technologies that are appropriate forthe factor prices prevailing in developing countries. Nonetheless, where R&D is

performed in developing countries, the expenditures have been found to generatesignificant efficiency gains in those countries, both within and across industries(Bernstein, 1989). Since foreign affiliates have access to the superior knowledge

base provided by the parent firm, their R&D expenditures may perform betterthan local R&D expenditures.

The question of intra-firm technology transfer has been addressed directly intwo recent studies by Urata (1999) and Urata and Kawai (2000), on the basis offirm-level data on Japanese manufacturing affiliates operating in Asia. They

conducted regression analyses to examine the determinants of intra-firmtechnology transfer. The dependent variables used for empirical analysis includeboth qualitative and quantitative indicators reflecting the extent and type of

technologies transferred44. One quantitative indicator used for regression analysis

43 Rasiah (2001) argues, in reference to the development of small and medium-scale industries inMalaysia, that one reason why small machine tool firms in Penang perform better than those in theKelang Valley is differences in the quality of government-business co-ordination.44 Urata (1999) applied ten different kinds of qualitative technology indicators to the probitregression analysis. These indicators include operational technology, maintenance and inspection,process and quality control, design technology, development of new products and the introduction ofnew technology.

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is the ratio of a foreign affiliate’s TFP level to that of its parent firm45. Theirregression analyses show both expected and unexpected results. First, among thecharacteristics of host countries, the level of education is found to be statistically

significant and positive in all cases. Second, reliance on parent firms in the formsof equity holdings, supply of personnel and purchase of capital goods is shown topromote intra-firm technology transfer. Third, experience in industrial activities

also tends to have a positive effect on intra-firm technology transfer, but this isstatistically significant only for Asian affiliates in textiles and electricalmachinery. Fourth, in contrast, the technical capability of foreign affiliates,

measured in terms of R&D expenditures and royalty payments, is found to bestatistically insignificant in most cases and to have the wrong sign. Finally,technology transfer requirements imposed by host governments are shown to have

an unexpected negative effect on intra-firm technology transfer in many cases.

5.2　Technology Transfer and Host-country Conditions

As discussed above, FDI may disseminate technology in a host country invarious direct and indirect ways. Although some studies have attempted to

examine the specific effects of each of the modes of transfer discussed, it is hardlypossible to disentangle the effects of the various channels when assessing howtechnology transfer through FDI affects the productivity growth of host-country

firms. Researchers take the view that the technological gap which may existbetween local firms and MNE affiliates is revealed in the observed difference inthe level of TFP. The effect of technology spillovers then should be captured by

changes in the level of TFP observed at the firm (or plant) level, after controllingfor the impact of other variables that may influence the firm’s productivityperformance. Following this methodology, most empirical and technical studies

attempt to test various hypotheses regarding the beneficial impact of FDI as amode of technology transfer to the host economy46.

The main results of 15 recent studies based on microeconomic data aresummarised in Annex Table 5.1. A number of studies indicate efficiency gains as aresult of technological spillovers from MNE affiliates to local firms in the same

industry. These include Blomström and Persson (1983), based on Mexico’smanufacturing census data for 1970; Blomström and Sjöholm (1999), using

45 It is assumed that the difference in technological level between an affiliate and its parent firm isexpressed as the ratio of their TFP levels. The cross-section regression equations were estimatedseparately for the textiles, chemicals, general machinery and electrical machinery industries, as wellas for those industries combined, with industry dummies (see Urata and Kawai, 2000).46 As mentioned above, Urata (1999) also used several qualitative technology indicators.

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Indonesia’s industrial survey data for 1991; and Haskel et al. (2001) on the basisof the United Kingdom’s annual census data for 1973-92. Other studies suggest,however, that the effects of FDI have not always been beneficial for local firms.

Haddad and Harrison (1993) find no positive results for Morocco in the late 1980s.Aitken and Harrison (1999) find a positive correlation between foreign presenceand TFP growth in Venezuela, but conclude that this may be misleading if MNEs

are attracted by sectors that are more productive in the first place. Okamoto’s(1999) empirical study on the US auto parts industry also finds only a modestdegree of technology transfer from Japanese assemblers to US independent parts

suppliers, and the author argues that the improvement in productivity observedin the 1980s and early 1990s may be a result of increased competitive pressuresrather than technology transfer per se47.

The diverse experiences of these and other countries suggest that thepositive spillover effects of FDI are not automatic, but may be affected by various

host-industry and host-country characteristics. Several of these characteristicshave been studied and tested. One of the most prominent is the “technology gap”between MNE affiliates and local firms in the host country. According to this

argument, spillovers should be easier to identify empirically when thetechnological attributes of local firms match those of the MNE affiliates. Kokko(1994) and Kokko et al. (1996) provide evidence for this hypothesis and find that,

for Mexico and Uruguay, spillovers are difficult to identify in industries whereforeign affiliates have much higher productivity levels than local firms.Furthermore, spillovers can be more easily recognised when foreign firms are not

“self-contained enclaves”. Kokko et al. (1996) argue that a high technology gapcombined with low competition prevents spillovers to the host economy.

Given the level of local firms’ capabilities, one of the most critical issuesregarding the transfer of technology is whether these technologies are appropriatefor local firms and can enable them to compete effectively in the global market.

Many studies have suggested that this is not always the case, and that firms willin fact have to make a variety of investments to benefit from technology inflows.The capability of host-country firms to “absorb” foreign technology appears to be

an important determinant of the size of the realised spillovers. As noted earlier, adefining characteristic of joint ventures and firms affiliated with foreign MNEs, as

47 The issues of reverse causality (observed higher productivity in the MNE sector is the causeinstead of the consequence of FDI) and omitted variables (higher productivity is due to unobservedfactors, independent of FDI), as well as the econometric techniques designed to redress them, arediscussed at length in Chapters Ⅲ and Ⅳ.

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opposed to local firms with no foreign partners, is the relative importanceattached by the former groups of firms to the provision of training programmesand the acquisition of new technologies (Djankov and Hoekman, 1999).

In addition to the relative difference in the technological capabilities of theMNE and the local firm, the absolute level of absorptive capacity is also important.

Keller (1996), for example, states that access to foreign technologies alone is notenough to increase growth rates if the country’s stock of human capital remainsunchanged. Some evidence for this argument is provided by Perez (1998), whose

study is based on firm-level data on the Italian manufacturing sector for the years1989-91. His analysis shows that foreign presence is likely to have a positive effecton the productivity growth of domestic firms in specialist and scale-intensive

sectors (e.g. electrical components, precision machinery, base chemicals, metalproducts and motor vehicles), while no similar evidence was found for science-based sectors, such as the pharmaceutical, fine chemicals, electronics and

information technology industries. Citing the latter examples, Perez argues thatstrong foreign presence does not necessarily help domestic firms to develop intechnologically more advanced sectors.

More generally, many developing countries do not meet the human capitalthreshold required for recipient countries to benefit from technology spillovers

through FDI (see Chapter Ⅲ). A recent study by Kokko et al. (2001) finds similarevidence for Uruguay, pointing to the importance of past experience inindustrialisation as a pre-condition for international transfer of technology. This

result may be interpreted as an indication that local firms in the host economylack absorptive capacity.

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Annex Table 5.1. FDI and Technology Transfer: Literature Survey

Authors (year) Data/coverage Estimation technique Major findingsBlomström and Persson(1983)

Mexico’s 1970 Census of Manufactures atthe four-digit level (215 industries), brokendown by ownership (private and foreign);a 15 per cent cut-off point is used forforeign ownership. State-ownedenterprises are excluded.

Cross-section, OLS regression analysis ofthe determinants of labour productivity indomestically owned private firms, with theforeign share of employment in each industryas an explanatory variable.

A positive and statistically significantcoefficient was found for the relationshipbetween labour productivity and the foreignshare variable.

Haddad and Harrison(1993)

Panel data on Moroccan industrial firmsduring the 1985-89 period.

Panel data regression analysis of the impactof foreign affiliates’ asset share onproductivity growth.

No significant relationship found betweenhigher productivity growth in domestic firmsand greater foreign presence in the sector(partly due to the distortionary effects ofimport protection).

Kokko (1994) Mexico — essentially the same data baseas that used by Blomström and Persson(1983).

Cross-section, OLS regression analysis ofthe determinants of labour productivity indomestically owned private firms, with focuson different market characteristics.

The interactive term of large productivitygaps and large foreign market shares tendsto exert a negative impact on productivity inlocal private firms.

Kokko (1996) Mexico — see Blomström and Persson(1983) and Kokko (1994).

3SLS estimation of a simple simultaneousmodel of labour productivity in locally ownedand foreign-owned firms.

Labour productivities of local and foreignfirms are determined simultaneouslybecause of competition when suspected“enclave” industries are excluded from thesample.

Kokko, Tansini andZejan (1996)

A plant-level survey of the Uruguayanmanufacturing sector in 1988, involving159 private locally owned plants.

Cross-section regression analysis of theimpact of foreign presence on labourproductivity in private locally owned plants

The coefficient of foreign presence (foreignoutput share measured at the four-digitindustry level) is found to be positive andstatistically significant only in the sub-sample with small technology gaps.

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Annex Table 5.1. FDI and Technology Transfer: Literature Survey (continued)

Authors (year) Data/coverage Estimation technique Major findingsBlomström and Sjöholm(1999)

1991 survey data on over 13 000Indonesian establishments withmore than 20 employees, withindications about domestic andforeign ownership (majority orminority).

Cross-section regression analysis of theimpact of foreign ownership on labourproductivity in Indonesian manufacturingand technological spillovers to local firms.

Foreign ownership is found to be a significantdeterminant of labour productivity in manufacturing.Positive intra-industry spillovers from FDI are found,but the degree of foreign ownership (minority ormajority) has little impact on them.

Perez (1998) Firm-level data on the Italianmanufacturing sector for the years1989-91, covering over 4 000 firms,both domestic and foreign.

OLS regression analysis of the impact offoreign presence (measured by the share oftotal employment) on the dispersion oflabour productivity.

Foreign presence is found to have a statisticallysignificant impact on productivity improvements ofdomestic firms in both specialist and scale-intensivesectors, but no similar evidence is found for science-based sectors.６

Sjöholm (1999) 1980 and 1991 industrial surveydata for Indonesia, with a sample ofover 2 800 establishments havingmore than 20 employees for bothyears.

OLS regression analysis of the impact offoreign presence (measured by the share ofgross output) on the growth of value addedand labour productivity in local firms at thenational, provincial and district levels.

Intra-industry spillovers are found to be statisticallysignificant at the national level.The hypothesis that geographical proximityincreases spillovers is not supported by the resultsof regression analysis.

Aitken and Harrison(1999)

Venezuela’s annual survey ofindustrial plants (more than 4 000plants) over the 1976-89 period(except for 1980).

Panel regression analysis of the impact offoreign ownership on TFP and output atboth plant and sector levels.

Small plants (employing fewer than 50 workers) withhigher foreign ownership tend to exhibit positiveproductivity gains. However, foreign ownership hasa negative effect on the productivity of domesticfirms in the same industry.

Djankov and Hoekman(1999)

Firm-level survey of Czechenterprises for 1992-96 with a fullsample of over 500 firms, bothdomestic and foreign (including jointventures).

Panel data regression analysis of theimpact of foreign presence (measured bythe share of assets) on TFP growth of firmswith different types of ownership.

FDI is found to have a positive impact on TFPgrowth of recipient firms.Joint ventures and FDI appear to have a negativespillover effect on firms that do not have foreignpartnerships.

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Annex Table 5.1. FDI and Technology Transfer: Literature Survey (continued)

Authors (year) Data/coverage Estimation technique Major findingsOkamoto (1999) Plant-level production data (1992) on the

US auto parts industry, including samplesof Japanese and US independent firms,joint ventures and other manufacturers.

Cross-section regression analysis of theimpact of business ties to Japanese autoassemblers on TFP growth rates in USindependent suppliers.

Only a modest degree of technology transferfrom Japanese assemblers to USindependent suppliers between 1982 and1992 was found.

Okamoto and Sjöholm(1999)

1990 and 1995 industrial survey data forIndonesia with a sample of over 16 000establishments having more than 20employees, both foreign and domestic.

Decomposition analysis of aggregate TFPgrowth rates between 1990 and 1995 intoseveral factors, calculated at ISIC three-digitlevel.

The contribution of foreign plants toaggregate TFP growth exceeds their outputshare. Foreign plants have a positive fixedeffect, which may be due to their access toparent firms’ technology.

Urata and Kawai (2000) Firm-level data compiled from a MITIsurvey in 1993, including 266 parent firmsand 744 overseas affiliates in fourindustries (textiles, chemicals, generalmachinery and electrical machinery).

Cross-section regression analysis of thedeterminants of intra-firm technologytransfer, measured by the ratio of the TFPlevel of an overseas affiliate to that of itsparent firm, with both firm-specific and host-country characteristics included asexplanatory variables.

The educational level and past experience inindustrial activity in the host country tend tohave a positive effect on intra-firm technologytransfer. However, a technology transferrequirement imposed by the host countrydoes not yield the expected outcome.

Haskel, Pereira andSlaughter (2001)

Plant-level panel data for all UKmanufacturing covering 1973-92, basedon the country’s Annual Census ofProduction.

Panel regression analysis of the impact offoreign presence (measured by the share oftotal employment) on TFP growth ofmanufacturing plants.

Productivity spillovers in the same industryare found to be positive and statisticallysignificant (but regional spillovers are not).

Kokko, Zejan andTansini (2001)

Firm-level data for the Uruguayanmanufacturing sector in 1988, including126 foreign-owned firms, using a10 per cent cut-off point for foreignownership.

Cross-section regression analysis of thedeterminants of labour productivity indomestically owned firms, with the foreignshare of total output at the four-digit industrylevel as an explanatory variable.Probit regression analysis of thedeterminants of domestic exports at the firmlevel, with the foreign presence variableincluded on the right-hand side of theequation.

Foreign firms established before 1973 tend togenerate positive spillovers to labourproductivity of local firms, while the impact offoreign firms established after 1973 is theopposite.The impact of foreign firms established after1973 on exports of local firms is found to bepositive and highly significant, while there isno sign of export spillovers from foreign firmsestablished before 1973.

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Chapter Ⅵ FDI, Privatisation and Corporate Governance

Cross-border mergers and acquisitions (M&As), as opposed to greenfieldinvestment, have played a central role in the recent surge in global FDI flows (seeChapter Ⅱ). Privatisation of state-owned enterprises accounts for a large share of

M&As in many developing and transition economies, notably in Latin America,Eastern Europe and the former USSR. Privatisation has been a core component ofthe structural reform measures these economies have undertaken to reduce budget

deficits, consolidate public finances and rebalance government resources to theircore functions. In the 1990s, divestiture of state enterprises reached public utilitysectors, including power and telecommunication services that had previously been

considered natural monopolies.

Since the 1997-98 financial crisis, a number of Asian countries have begun to

embrace privatisation and deregulation policies in order to revive their economies.However, privatisation programmes, particularly those involving public utilities,have raised public concern and even given rise to protests in some parts of the

region. California’s power crisis in 2001, although deregulation per se was not itsprimary cause, has also drawn attention to the potential risks of reforming publicutilities (see Box 6.1). This incident appears to have delayed plans to deregulate

monopoly electricity companies in Korea, Malaysia and other countries in Asia48.Moreover, foreign participation in national privatisation programmes is apolitically sensitive issue in many Asian countries.

As foreign participation is nonetheless a key instrument for achievingprivatisation goals and improving corporate governance in newly privatised

enterprises, and since empirical analysis and informed policy discussionconcerning the relationship between privatisation and FDI in Asia remain limited,recent experiences in Latin America (Brazil in particular) as well as in a number of

OECD countries can provide useful lessons to Asian policymakers. This chapterattempts to synthesise the materials available and discusses some policy issues. Itbegins with a brief overview of privatisation trends in the 1990s, followed by

discussion of recent experiences in Latin America, notably in Brazil. The lastsections present an assessment of privatisation policy and its implications forcorporate governance.

48 See International Herald Tribune, 8 February 2001.

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Box 6.1. The Power Crisis in California: What Went Wrong?

“[W]hile the deregulation was indeed flawed, the flaws did not cause thecatastrophe” (Paul Krugman, The New York Times, 20 February 2001).

In 1996, California became the first state in the United States to deregulate itselectricity market. According to the State Assembly bill, the move was supposed to createa “market structure that provides competitive, low cost and reliable electric service”.Before deregulation, the state’s electric sector was a government-regulated monopoly.Under deregulation, investor-owned utility companies, such as Southern CaliforniaEdison and Pacific Gas and Electric, sold most of their power-generating plants to other(unregulated) private companies and became buyers of wholesale electric power. Theywere also required to transfer operational control of transmission lines and power grids toa private non-profit organisation, called the Independent System Operator. As aconsequence, they retained ownership and control only of the distribution systemssupplying electricity to homes and businesses. These utility companies must now buy theirpower at prices that are set daily at auction by the California Power Exchange (PX), whichis overseen by the Federal Energy Regulatory Commission. What went wrong, then?

As Krugman noted above, the design of deregulation was flawed. First, while thewholesale price was set by the market, the retail price continued to be regulated.Deregulation prevented the utility companies from passing on price increases to theirconsumers until at least 31 March 2002. Second, under deregulation, utilities were notpermitted to negotiate long-term contracts with power generators. The rigidity of retailprices thus made it harder for the state to cope with the power crisis that loomed during2000. Wholesale prices in 1998-99 were estimated at an average of 16 per cent abovemarginal cost. In 2000, however, prices skyrocketed a further 500 per cent (McMillan,2001, p. 8). Unable to recoup these higher costs from their customers, the utilitycompanies rapidly ran out of money, with the two largest companies claiming that theircombined losses exceeded $9 billion at the end of 2000.

The primary reason for California’s power crisis, however, predated deregulation:robust economic growth considerably raised the state’s demand for power, whilegeneration capacity actually declined by 2 per cent between 1990 and 1999 (ibid., p. 6).Deregulation simply helped to reveal this fundamental problem of demand-supplymismatch.

In short, California’s power crisis makes it necessary for policymakers to take ahard look at where prices should be to reflect electricity’s true cost and to encourageenergy conservation by end-users. It also offers an expensive lesson to regulators: theproblem of damaging price hikes or supply interruptions in deregulated markets will haveto be taken seriously.

6.1 Privatisation Trends in the 1990s

Over the last two decades, privatisation has become part and parcel of

structural reform programmes in many countries, both OECD and non-OECD. Theinitially timid progress recorded in some pioneering countries (United Kingdom,Chile, New Zealand) has been matched and sometimes surpassed by other

countries that have joined the privatisation bandwagon, first in the developingworld (Argentina, Mexico, Malaysia), then in Europe (France, Italy), and finally in

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transition economies49. In the 1990s alone, close to $1 trillion worth of state-ownedenterprises have been transferred to the private sector world-wide (OECD, 2001b,p. 43).

In dollar terms, global privatisation proceeds grew by 18 per cent per annumbetween 1990 and 1999, with temporary drops recorded in 1992 (the Europeancurrency crisis) and again in 1998 (financial crises in East Asia and Russia). The

wave of privatisation is driven by a host of factors, including the need to reducebudget deficits, attract FDI flows, improve corporate efficiency, and liberalise andderegulate power, telecommunication and other service markets. In Europe,

following the signing of the Maastrich Treaty in 1992, privatisation activitiesaccelerated in the second half of the 1990s as countries tried to reach the goals setfor the creation of the European Monetary Union (EMU). In 2000, however, global

privatisation proceeds fell to $100 billion, nearly 30 per cent below the 1999 level.Much of this drop was due to reduced privatisation activity in the OECD countries,partly reflecting the fact that few state assets still remain to be sold in competitive

sectors (see Figure 6.1).

Figure 6.1. Global Trends in Privatisation Revenues

In non-OECD countries, more than half of total cumulative privatisation

49 Possibly the first large-scale sale of a public enterprise was the Volkswagen issue in the early 1960s,but the dramatic fall of the share price after markets were hit by the Cuban missile crisis had alasting negative impact on equity ownership culture in Germany (see Goldstein, 2001).

0

20

40

60

80

100

120

140

160

180

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

$ bi

llion

OECD countries Non-OECD countries

Source: OECD (2001e).

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revenues for the 1990-99 period accrued to one region, Latin America, followed byEastern Europe and Central Asia. These regions taken together accounted fornearly 80 per cent of total privatisation revenues in the 1990s, while the share of

East Asia (excluding Korea) was only 14 per cent (Figure 6.2). Moreover,privatisation in non-OECD countries was heavily concentrated in infrastructureprojects. Three sectors — infrastructure, financial services and other services —

accounted for almost two-thirds of total privatisation revenues during this period(Figure 6.3).

Figure 6.2. Privatisation Revenues by Major Non-OECD Region, 1990-99

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14

21

9

Latin America East Asia Europe & Cen. Asia Other regions

Source: World Bank (2000 and 2001).

Figure 6.3. Privatisation Revenues in Non-OECD Regions by Major Sector, 1990-99

49

16

19

12

4

InfrastractureIndustryPrimary sectorFinancial servicesOther services

Source: see Figure 6.2.

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Privatisation has also served as a major channel for attracting FDI flows toLatin America. The aggregate value of privatisation revenues between 1990 and1999 reached $146 billion, which is equivalent to 45 per cent of total FDI flows into

the region during the same period (Figure 6.4). In contrast, privatisation in EastAsia has been rather limited from a quantitative point of view, though policies inthis domain have existed since the 1980s in Korea and several ASEAN countries50.

Most FDI inflows to the region have taken the form of greenfield investment, asprivatisation has attracted relatively little FDI (Figure 6.5). Such regionaldifferences in the relationship between privatisation and FDI deserve further

discussion from the political-economy point of view.

Figure 6.4. Privatisation and FDI Inflows in Latin America

0

10

20

30

40

50

60

70

80

90

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

$ bi

llion

FDI inflows Privatisation revenues

Source: see Figures 2.3 and 6.2.

50 See Fukasaku (2001) for a detailed analysis of privatisation trends in East Asia.

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Figure 6.5. Privatisation and FDI Inflows in East Asia

0

10

20

30

40

50

60

70

80

90

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

$ bi

llion

FDI inflows Privatisation revenues

Source: see Figures 2.3 and 6.2.

6.2　Why is Latin America More Advanced in Privatisation?

Privatisation is as much a political as an economic process, requiring thecreation of supportive coalitions against strong vested interests. Privatisation is

also a typical example of a “collective action” situation in which the actors likely togain from it are widely dispersed. It is thus politically easier for beneficiaries of thestatus quo to organise opposition than it is for future beneficiaries to create a

support group. Moreover, in developing countries with underdeveloped capitalmarkets, the appeal of privatisation through the public offering of state-ownedenterprises would be rather limited in terms of coalition building in the political

process.

Experiences in the 1990s suggest that the intrinsic allure of free-market

economics has proven less important a factor for the success of privatisationprogrammes than political conjunctures (Armijo, 1998). The nature and gravity ofeconomic crises have deeply influenced both the perceived need for radical political

changes and the central themes of the political debate. The more severe thegovernment’s fiscal deficits and the greater the contribution of state-ownedenterprises to these deficits, the quicker the government resorts to divestiture to

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solve its structural problems. Active participation by foreign investors can be seenas key to successful privatisation programmes, not only for the obvious reason thatit enlarges the pool of potential buyers, but also because foreign investors may

provide access to modern technologies and management methods and add pressurefor “getting regulation right” in the newly privatised sectors.

Another important issue is the choice of firms to be sold and the method ofsale. It is vital that the economic goals to be met through divestiture areunderstood, in particular the choice between an immediate reduction of

macroeconomic imbalances and a medium-term improvement in corporateefficiency. The least productive enterprises are hard to dispose of, which may makeit necessary to concede extremely easy terms in addition to a low price, unless of

course the government decides to eliminate such enterprises altogether. At thesame time, countries in dire economic straits need quick “leading cases” to buildtheir reputations in the eyes of foreign investors. Thus, governments have often

chosen to start with the best managed and more profitable enterprises, such asthose in the telecommunications industry, where state assets are expected to bemore attractive to international investors. Unfortunately, such industries present

technological and tariff complexities, requiring sophisticated tools for assetvaluation and regulation that few developing countries possess.

6.3　Privatisation: Brazilian Style

During the 1950s and 1960s, successive Brazilian governments used state-

owned enterprises (SOEs) as an indirect form of public management to acceleratethe country’s industrialisation and infrastructure development. The adverseeconomic situation — domestic and external — after the first oil shock made it

necessary to re-orient this policy, and privatisation thus entered the agenda. For avariety of economic and political reasons, however, it was not until the early 1990sthat the government made privatisation one of its top priorities for structural

reform.

Soon after taking office in March 1990, the Collor government sent to

Congress Provisional Measure 155, later converted into Law 8031, which createdthe National Privatisation Programme (PND) and established most of the rulesand procedures governing it today. The PND focused on selling large public

enterprises in the industrial sectors (e.g. steel, petrochemicals and fertiliser) thathad been considered strategic in the development model of the past. The sale thatbest exemplified this change was probably that of Usiminas, an integrated steel

company, in October 1991.

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In September 1992, President Collor was impeached and replaced by VicePresident Itamar Franco (now governor of Minas Gerais). The Franco governmentsought to change the institutional framework in order to place more emphasis on

fiscal considerations and to widen participation in the PND to include foreigninvestors. The fiscal impact of privatisation was negligible at that stage, however,simply because the PND was a small-scale programme in macroeconomic terms.

The most pressing problem for the Cardoso government which took office in1995 was — and still is — the weakness of public finances. President Cardoso

stated that “[w]ith the Federal Treasury carrying, directly and indirectly, debts ofmore than $200 billion, it is doubtful that the government will be able to undertakelarge public investments over the medium term” (Cardoso, 1995, p. 10). Under

these circumstances, the government sought to strengthen the institutional side ofthe privatisation programme by creating the cabinet-level National Council forPrivatisation (CND), which is directly accountable to the President; to broaden the

scope of privatisation by launching privatisation programmes at the level of thestates and extending the PND to public utilities and mining; and to increase cashrevenues and investment commitments in the sectors to be privatised.

This policy initiative led to the enactment of the Concessions Law (Law 8987)in February 1995 and to various constitutional amendments later that year. By

breaking public monopolies and granting concessions to the private sector, this lawpaved the way for privatisation in a number of sectors: telecommunications,electricity and gas, railways, highway construction, ports and airports, water

supply and basic sanitation services. As a result, the Brazilian privatisationprogramme had generated revenues of close to $90 billion as of March 1999, one ofthe highest totals in the world. At the same time, the speed and scope of

privatisation have raised some concern over the uneven development of regulatoryregimes across sectors.

Establishing a modern regulatory system (adequate, transparent and stablerules for private operation) remains a key challenge in Brazil. New regulations topromote market competition were put in place in the telecommunication sector

before the sale of Telebrás, the former national monopoly, in July 1998. Thechanges have been impressive. A long-standing state monopoly regulated by aministry has been converted into a competitive private industry, with the

participation of both domestic and foreign investors.

In the power sector, however, regulatory reform has been introduced only

gradually. This reflects the complexity of this sector’s institutional and regulatory

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environment: the federal government owned the power generation andtransmission assets, while state governments owned the distribution companies aswell as some vertically integrated utilities. The combination of ownership problems

and debt in many state-owned utilities has prevented privatisation from beingimplemented as a one-shot, all-inclusive deal. A key challenge for this sector is tocreate a regulatory and market environment that leads private investors to make

the long-term investments needed to meet the country’s growing demand forelectricity51.

6.4　An Assessment of Privatisation Policy

There is a general consensus that, in OECD countries, ownership changes

have considerably improved firm-level performance in terms of productivity andprofitability (see e.g. Meggison and Netter, 2001). Privatisation has also helped toincrease the depth and liquidity of equity markets, although early observers of the

British experience argued that these goals should be achieved throughinstruments other than the sale of state enterprises at a considerable discount(Jenkinson and Mayer, 1988). Developing economies have recorded significant

increases in profitability, operating efficiency, capital spending, output andemployment, and these increases are usually greater in countries with higher percapita income (Boubakri and Cosset, 1998)52.

Overall, privatisation has increased consumer welfare, but the degree ofeconomic success depends crucially on the post-privatisation market structure

shaped by the regulation that is put in place. The substitution of private for publicownership has been accompanied by the emergence of new regulatory challengesfor policymakers. First, in the natural monopolies that previously formed the core

of the public enterprise sector (telecommunications, power, water, transportservices), it is important to prevent the new private owners from simply pocketingmonopoly rents. The policy issues and problems facing Brazil’s public utility

sectors are widely shared by OECD Member countries. Indeed, sales of publicutilities accounted for almost 70 per cent of total privatisation revenues realised by

51 For a full treatment of the Brazilian privatisation programme, see Goldstein (1999) and Fukasakuand Pineiro (1999).52 In the case of transition economies, empirical tests of the relationship between enterpriseperformance and ownership generally refute the hypothesis that privatisation per se is associatedwith improved performance (e.g. Estrin and Rosevaer, 1999). The belief that mass privatisationwould unleash entrepreneurial energies by providing powerful incentives for efficient restructuringhas also proved naive. The chances of fostering entrepreneurship appear to be greater in a gradualistenvironment permitting negotiated solutions to restructuring as opposed to market-driven reforms(Spicer et al., 2000).

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OECD countries from 1993 to 1998. As in Brazil, OECD governments have soughtto achieve multiple objectives — economic, political and financial — in pursuingtheir privatisation programmes. Weaknesses in the regulatory framework have

sometimes reduced the benefits of privatisation and deregulation, particularly inthe electricity industry (Gonenc et al., 2001).

Second, there is broad consensus that public authorities must devise sectoralpolicies that introduce and maintain competition, while at the same timeestablishing a sound regulatory framework in remaining monopolies. Public

authorities must also ensure that transactions are transparent; convince investorsthat their investments are secure; and negotiate, monitor and enforce contractswith private suppliers of management and financing. In addition, they need to

ensure that resources from privatisation sales are put to productive uses, and tomanage the political and social tensions that inevitably arise as enterprise reformsare implemented, especially the critical issues of foreign ownership and labour

layoffs.

There is much less agreement, however, on how countries that need to

consolidate their initial reforms should approach the next set of challenges (knownas “second-generation” issues). In general, these issues are related to post-privatisation disputes and renegotiations between governments and the private

sector and to the mechanisms necessary to promote competition and investment inthe reformed industries53.

6.5 Implications for Corporate Governance

Corporate governance is a burgeoning subject in the new institutional

economics concerned with the mechanisms whereby economic systems (in theirbroadest possible sense) cope with the information and incentive problemsinherent in financing investments. In developing countries, corporate ownership is

highly concentrated in the hands of either a small number of families or the state54.It is also difficult to monitor managers because well-connected firms, and a fortioriSOEs, do not face a credible bankruptcy threat.

Privatisation and corporate governance are linked in two main ways. First,the sale of SOEs exposes them to take-over and bankruptcy threats, thereby easing

53 See OECD (2001d) for further discussion.54 See Claessens et al. (1999) for a detailed discussion of the structure of corporate control in EastAsia. See also Oman (2001) for country case studies on corporate governance (Argentina, Brazil,Chile, China, India, Malaysia and South Africa).

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the corporate governance problems proper of public ownership. Second,privatisation provides an opportunity to modify the distribution of ownershiprights among different classes of investors, by extending public listing among large

firms, increasing the number of small shareholders and reducing ownershipconcentration. In view of the goal of creating a “people’s capitalism”, it is thusimportant to reconcile two opposing imperatives: providing an appropriate

mechanism for protecting small shareholders, while at the same time allowingmanagement the flexibility required to pursue long-term corporate goals. Thepotential improvements in technical efficiency following transfer of control may be

jeopardised if corporate control is not contestable: in this case, and especially ifconduct regulation proves insufficient to open up protected markets, managers canexploit rents accruing from market position without having to worry about the

threat of take-overs. Privatisation policies should take such factors into account,making it imperative to introduce reforms and redress perceived inefficiencies.

While creating “people’s capitalism” has always ranked high amonggovernments’ goals, tackling the issues that remain after ownership is transferredfrom public to private hands and when no (absolute) majority shareowner emerges

has seldom been an overriding concern. Governments have great discretion inpricing the state-owned enterprises they sell, especially those being sold via publicshare offering, and they use this discretion to pursue political and economic ends.

Most experiences, however, suggest that privatisation has only limited powerto change the modes of governance prevailing in each country’s large private

companies. In the United Kingdom, a country whose privatisation policies areoften referred to as a benchmark, “control [of privatised companies] is not exertedin the forms of threats of take-over or bankruptcy; nor has it for the most part come

from direct investor intervention” (Bishop et al., 1994, p. 11)55. The slow but steadydecline in the number of small shareholders, after the steep rise in the immediateaftermath of privatisation, highlights the difficulty of sustaining people’s

capitalism in the longer run. In Italy, privatisation was accompanied by alegislative effort aimed at providing non-controlling shareholders (both individualand collective investors) with more adequate safeguards and at creating conditions

that allow them to monitor managers. Successive governments, however, wereunsuccessful in broadening the number of large private business groups, eventhough enhancing the mobility of control to investors outside of the traditional core

55 Following three successive fatal accidents (19 September 1997, 5 October 1999 and 17 October2000), Britain’s rail infrastructure operator, Railtrack, was declared bankrupt on 7 October 2001 andput into receivership. This incident suggests that financial deregulation has pushed banks into givingup their role as rescuers of sick but socially important public service companies.

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of Italian capitalism was explicitly included among the authorities’ strategic goals.

Those countries which have chosen the mass (voucher) privatisation route

have done so largely out of necessity and face ongoing efficiency problems as aresult. More successful experiences, such as those of the United Kingdom andChile, indicate that mass sell-offs require the development of new institutional

investors, such as pension funds, which may later play an active role in corporategovernance56.

In sum, although the promise of privatisation has frequently been oversold,not least by many international organisations, its ills have also been greatlyexaggerated. When ownership transfer is accompanied by market liberalisation

and proper implementation of the new regulatory system, consumers and end-users in OECD and non-OECD countries alike have benefited in terms of widerchoice, higher quality and lower prices. Privatisation has also opened the door for

foreign investors, notably in Latin America. Regulatory agencies still facesubstantial challenges, however, if they are to ensure that the maximum benefitsare reaped from privatisation.

56 In Chile, for example, the take-over of the country’s dominant electricity utility, Enersis, one of thelargest in emerging markets, was stalled for some months in 1998 as pension funds objected tolucrative additional terms that managers had negotiated for themselves on the basis of importantagreements concerning the future strategic direction of Enersis — agreements about which theynever informed the other shareholders.

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Chapter Ⅶ Host-government Policies for Attracting FDI

In recent years, host-country governments throughout the world have playedan active role in attracting FDI. Many see FDI as vital to reinvigorate theirdomestic economies and strengthen their ability to compete in global markets. A

consequence of this trend has been intensified competition for FDI by both nationaland sub-national governments. Yet, while host-government policies maysubstantially influence the magnitude and quality of FDI inflows, the relative role

of different policy measures remains poorly understood. Moreover, developingcountries have expressed some concern in the context of the multilateral tradingsystem under the aegis of the WTO that the ability of host governments to regulate

the pattern of FDI inflows may have been significantly curtailed. It is thusimportant to have more informed discussion about the role of host-governmentpolicies for attracting FDI. This chapter aims to fill this gap by reviewing foreign

investment regimes in selected host economies and discussing their implicationsfor development policy. Before doing so, however, a brief discussion of the typologyof host-government policies is in order.

7.1　Incentive-based and Rules-based Measures

The foreign investment regime in a host economy comprises a wide variety ofgovernment measures aimed at regulating and attracting foreign investment.Table 7.1 lists the main types of regulatory and incentive measures applied by host

governments. Conceptually, it is important to distinguish two broad categories ofmeasures, “incentive-based” and “rules-based” measures, though in practice thisdistinction is not always self-evident57.

57 A case in point is the establishment of export-processing zones or special economic zones (e.g. inChina). This requires host governments to set rules for firms (both foreign and domestic) operating insuch zones, with legislation distinct from that governing the rest of the economy and often combinedwith certain incentive measures.

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Table 7.1. Foreign Investment Regime in the Host Economy:Main Types of Regulatory and Incentive Measures

Types of measures Examples1. Screening, admission

and establishment• Closure of certain sectors, industries or activities to FDI• Minimum capital requirements• Restrictions on modes of entry• Admission to privatisation bidding procedures• Establishment of special zones (e.g. EPZs) for FDI with legislation

distinct from that governing the rest of the country2. Fiscal incentives • Reduction in standard corporate income tax rate

• Tax holidays• Reduction in social security contributions• Accelerated depreciation allowances• Duty exemptions and drawbacks• Export tax exemptions• Reduced taxes for expatriates

3. Financial incentives • Investment grants• Subsidised credits• Credit guarantees

4. Other incentives • Subsidised service fees (electricity, water, telecommunications,transportation, etc.)

• Subsidised designated infrastructure (e.g. commercial buildings)• Preferential access to government contracts• Closure of the market to further entry or granting of monopoly

rights• Protection from import competition

5. Performancerequirements

• Local content (value added)• Minimum export shares• Trade balancing• Technology transfer• Local equity participation• Employment targets• R&D requirements

Sources: OECD (2001c, pp. 5-6), UNCTAD (1996, pp. 176-181), WTO (1998, Table 2).

Incentive-based measures provide for fiscal, financial and other incentives toforeign firms. Common fiscal incentives include a reduction in the standard incometax rate for a particular category of foreign investors, tax holidays, accelerated

depreciation allowances, duty exemptions and drawbacks, and export taxexemptions. Among the most important financial incentives are direct investmentgrants, subsidised credits and credit guarantees. In addition, “other incentives” are

often used to provide foreign investors with privileged access to certain types ofinfrastructure services. Incentive-based measures may be either grantedautomatically or targeted to specific purposes, with conditions relating to certain

pre-determined performance criteria.

Rules-based measures are a much broader category of government measures

that are applied to regulate directly or indirectly the scope and magnitude offoreign business activity in a host economy. Examples include rules on marketentry and rights of establishment (including protection from market competition),

protection of property rights (including intellectual property rights), the

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establishment of various types of “zones” within an economy, participation inprivatisation programmes, rules and procedures regarding dispute settlement, anddomestic regulations on environmental protection and workers’ rights.

Where environmental protection and workers’ rights are concerned, the use ofgovernment regulations and legal standards as a means of attracting FDI has

generated strong concern in both home and host countries. It is often claimed thatin competing to attract FDI, host governments may overtly or covertly relax theenforcement of such standards, thereby putting pressure on other governments to

follow suit. Although there is little empirical evidence of the so-called “race to thebottom” in either environmental or labour standards (see Box 7.1), this debate hasenhanced public awareness about host-country policies for attracting FDI58.

The next section begins by reviewing available materials (mostly obtainedthrough the Internet) with respect to foreign investment regimes in ten selected

Asian and Latin American economies. This is followed by discussions on somecontroversial issues regarding the use of incentive measures to attract FDI inflows.Much of the analysis and discussion presented in this section draws heavily on the

results of recent studies conducted at the OECD Development Centre andelsewhere59.

58 The case of export-processing zones( EPZs) has attracted particular attention in this debate,because the phenomenal growth of EPZs since the 1970s is seen by some as evidence of deliberatelylowering of labour standards. A recent study by the ILO (1998) finds that adequate labour standardsand a sound system of labour-management relations are indeed widely lacking in EPZs, but it alsoleaves little doubt about the dynamics of change that market forces are imposing on firms thatoperate in EPZs: “Today, globalisation places the emphasis on speed, efficiency and quality as well ascost … shifting the focus from cheap labour to productive labour. For countries to remain competitive,they must get this mix of cost and quality factors right by raising the capacity of their humanresources, ensuring stable labour relations, and improving the working and living conditions of zoneworkers.” The study further notes that “countries which have established trade union presence in thezones do not appear to have suffered any loss of investment”, and that “none of the enterprisesinterviewed [for the ILO study] stated that a lack of worker organisation was an incentive to invest”(ibid., p. 12).59 See inter alia Moran (1998), OECD (1998), Oman (2000) and UNCTAD (1999 and 2001).

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Box 7.1. Policy Competition for FDI: A Race to the Bottom?

The environmental and social dimensions of foreign investment have recentlybecome a matter of intense controversy between certain home and host countries. Theconcern is that governments of OECD and developing countries alike, caught in aprisoner’s dilemma, might find it difficult to resist competitive pressures, causing a “raceto the bottom” in environmental and labour standards. There is, however, little empiricalevidence supporting this view.

Environmental StandardsRecent studies have found little evidence that US firms, or other OECD-based firms,

have moved production to take advantage of lower environmental standards in anothercountry60. A main reason is that the costs of complying with anti-pollution laws haveproved relatively modest on the whole, and any attractiveness that weak environmentalrules may have is simply swamped, in most cases, by other factors. It is often moreefficient to adhere to a single set of environmental practices world-wide than to scale backpractices at a single location. The high local visibility of large multinational investors canmake them particularly attractive targets for local enforcement officials. The memory ofsuch events as the Bhopal disaster (India) in 1984 and the ensuing problems faced byUnion Carbide have heightened many investors’ awareness of their potentialenvironmental liabilities when they invest abroad. Moreover, competition for FDI inknowledge-intensive activities can create upward pressure on environmental standards.This reflects the growing desire for corporate managers to locate these activities incommunities where their productivity levels and competitiveness benefit from highstandards of environmental protection. The spillover benefits to firms of “clustering” and“agglomeration economies” tend in turn to attract other corporate investors, thusamplifying the attractiveness of communities that set and enforce relatively highstandards of environmental protection.

Core Labour Standards 61

Data gathered by the OECD on freedom-of-association rights (arguably the mostimportant core labour standard, along with the right to bargain collectively) reveal amarked difference between OECD and non-OECD countries. However, these data do notsupport the hypothesis of a race to the bottom in core labour standards, because they showno significant deterioration of freedom-of-association rights in developing countries (orOECD countries) over the last 20 years. On the contrary, they show that the move todemocracy in developing countries has been accompanied in several — notably in LatinAmerica — by some improvement in the protection of workers’ right to associate.Furthermore, some recent studies show that since 1980, countries with high labourstandards have maintained or increased their share of global FDI inflows(notwithstanding the importance of flows to China, a low-standards country). Similarly,low-standards countries have not increased their share of global exports. Two-thirds of 39countries with low labour standards have seen their international competitivenessstagnate or decline, as measured by unit labour costs, while 14 of 18 high-standardscountries have increased their international competitiveness62.

60 See Oman (2000) for a detailed discussion.61 Core labour standards are defined as workers’ right to associate, i.e. to form independent unions oftheir choice, and to bargain collectively; the prohibition of forced labour and of exploitative childlabour; and non-discrimination in employment.62 See Raynauld and Vidal (1998). See also OECD (2000) for further discussion.

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7.2　Some Observations from Case Studies

Annex Tables 7.1 and 7.2 present a snapshot of the legal and policy

framework currently applied to foreign investors in ten Asian and Latin Americanhost economies: Argentina, Brazil, Chile, China, Chinese Taipei, Colombia, India,Indonesia, Malaysia and Mexico. The countries were selected on the basis of two

criteria: the accessibility of legal materials and policy documents (includingarticles and policy analyses by consulting firms and newspapers) through theInternet, and the goal of presenting broadly comparable pictures of foreign

investment regimes in the two regions. Each annex table lists key regulatory andincentive measures in three major areas of interest to foreign investors: (1)openness to FDI (measured in terms of screening procedures for entry and

establishment of foreign firms, national treatment, existence and scope of negativelists and performance requirements), (2) fiscal and other incentives, and (3)protection of investments, notably protection of intellectual property rights and

dispute resolution procedures.

This review does not present an exhaustive list of regulatory and incentive

measures maintained by the host government. Rather, it should be seen asillustrative, providing a broad-brushed picture of the regulatory environmentfacing foreign investors today. It should be emphasised at the outset that despite

recent initiatives undertaken by many developing countries to liberalise theirforeign investment regimes, there remain considerable differences across regionsand countries. Several issues deserve particular attention.

First, the creation of a “level playing field” for domestic and foreign firms iswidely regarded as one of the pre-conditions for attracting FDI. In terms of

screening procedures for entry and the right of establishment, as well as thegranting of national treatment, it appears that Argentina, Chile and other LatinAmerican countries have instituted a more liberal legal framework than their

Asian counterparts. Although the latter have gradually streamlined registrationprocedures and introduced automatic approval for FDI, many countries in theregion, such as China, India and Indonesia, have maintained considerable control

over foreign investment at the entry phase and retained lengthy negative lists. Incontrast, Chinese Taipei and, more recently, Malaysia offer a more liberalenvironment. Ceilings on foreign equity, negative lists and performance

requirements such as local content requirements are being gradually phased out.Notwithstanding the considerable progress made in the aftermath of the 1997-98financial crisis and the commitment to creating the ASEAN Investment Area (AIA),

most Asian countries remain reluctant to liberalise their foreign investment

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regimes fully.

Second, greater emphasis on export orientation and international

competitiveness has generated renewed interest in human resource developmentand skill formation by host governments in the context of FDI policy. In thisrespect, many of the countries under review regulate the hiring of foreign workers

and impose training requirements on foreign investors. For instance, Malaysia, acountry that has no legal minimum wage, has provided various incentive schemesto promote technical and vocational training. In particular, the government has

established a Human Resource Development Fund to help finance the educationand re-training of workers, although incentives are linked to certain performancerequirements. Foreign companies are allowed to bring in the required personnel in

areas where there is a shortage of trained Malaysians to do the job, but only for acertain period, and subject to the condition that Malaysians are trained to takeover the posts eventually63. Export requirements are still in place in most special

zones, but apply to domestic as well as to foreign investors.

Third, protection of intellectual property rights (IPRs), which has a strong

influence on the magnitude and quality of technology transfer, is another keycharacteristic of the foreign investment regime in the host economy. Foreigninvestors often request host governments to strengthen the legal framework for

IPRs, and this issue is particularly sensitive for trade in electronic andpharmaceutical products, because these products are easily pirated. The scope andstrength of IPR protection differ significantly among host economies. In India’s

pharmaceutical industry, for example, patents apply to the manufacturing processbut not to the products themselves. India will have to bring its patent lawsregarding the pharmaceutical sector into conformity with the WTO’s TRIPS

Agreement by 2005. Almost all of the countries under review have ratified majorinternational agreements and conventions regarding protection of IPRs, andnational legislation has been amended and improved accordingly. With respect to

enforcement, however, there is still much room for improvement.

Fourth, regulations on tax treatment at the national and international levels

have become highly complex in many host economies, such as China. The rent-seeking and even corrupt practices of local officials in the provision of various taxincentives have given rise to some concern (see, for example, Oman, 2000, pp. 50-

54, and the studies cited therein). Some mechanisms adopted to counter this

63 See US State Department, Bureau of Economic and Business Affairs, “Malaysia CountryCommercial Guide 2000”, Chapter 7.

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tendency are the requirement that enterprises appoint accounting firms (e.g. inIndia) to deal with tax matters and computerise records of imported inputs andexport sales. In addition, the legal requirement to preserve documents related to

transfer pricing will have a positive impact on the tax system on the whole. Forinstance, India’s Finance Bill for 2001 has made it mandatory for persons enteringinto international transactions to keep information and documents. In Mexico,

documentation is required for all taxpayers, and compliance with thedocumentation requirement entitles the taxpayer to a 50 per cent reduction inpenalties64.

Finally, various forms of tax incentives have been widely used as a means ofattracting FDI in almost all the host economies under review, notably those in Asia.

In 1999, Chinese Taipei (a net capital exporter in East Asia) introduced acomprehensive tax incentive scheme to attract FDI65. Where financial incentivesare concerned, however, there is little information available in the public domain.

The cost of incentive measures will be discussed in more detail in the next section.

7.3 The Cost of Investment Incentives

Economists have long argued that governments’ use of discretionary, targetedfiscal and financial subsidies to attract investors is ineffective. An abundance of

studies, using both investor surveys and econometric methods, support this view66.The studies find that the overwhelming majority of major investors base theirdecisions concerning investment location much more on a site’s economic and

political “fundamentals” than on government subsidies. Among the keyfundamentals are the size and perceived growth potential of the market that a siteis well placed to serve, the likely long-term political and macroeconomic stability of

the site’s location, an adequate supply of productive, trainable workers, and theavailability of modern transportation and communications infrastructure.

All of this research and advice from economists seems, however, to have littleinfluence on the behaviour of the politicians and government officials whose job itis to attract corporate investors. These people keep launching new incentive

programmes, often argue vehemently that they cannot do their jobs without suchmeasures and seem largely to ignore the arguments of economists. Why?

64 “Transfer Pricing in Mexico”, PriceWaterhouseCoopers, www.pwcglobal.com/extweb/indissues.65 Asia Pacific Tax Notes, No. 10, July 1999, PriceWaterhouseCoopers, p. 18.66 See, for example, Reuber et al. (1973), Lim (1983), UNCTC (1992), Shah (1992), Rolfe et al. (1993)and Pirnia (1996).

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The reason is that studies showing that incentives are ineffective have largelyfailed to take adequate account of the fact that an investor’s choice of location,especially for a major new investment project (the kind governments most want to

attract), usually involves a two-stage, or multi-stage, decision-making process. It isstandard practice for an investor first to draw up a “short list” of sites that satisfyits “fundamentals test” — i.e. that meet or surpass the investor’s minimum criteria

with respect to fundamentals, irrespective of potential host governments’willingness to provide incentives — and then, in a second or later stage, to considerthe availability of incentives in making the final site selection.

Thus, although investors attach much greater overall importance to thefundamentals than to the availability of subsidies, discretionary incentives can

make a difference — even a decisive difference — in an investor’s final choice ofinvestment location. It is common, in fact, for investors to seek actively to playgovernments off against each another to bid up the value of incentives, once the

competing sites have passed investors’ fundamentals tests and have been short-listed as good potential sites.

While economists rightly claim that investors attach much more importanceto fundamentals than to incentives, the politicians and government officialscharged with attracting FDI are often equally right when they argue that

incentives can be effective, even decisive, and that it can be very difficult for themnot to offer incentives if they want to attract a major investment project. In short,governments that wish to compete for such investment often face a prisoner’s

dilemma67.

In principle, one should look both at the relative costs — i.e. compare the

costs of incentives to the benefits to be derived from the additional FDI attractedby incentives (FDI that otherwise would not have come to the country) — and atthe determinants or components of the costs per se. For our purposes, however, it is

largely sufficient to focus on the costs per se, though it is important to considerboth direct and indirect costs. We can then address the question of howgovernments might best respond to the prisoner’s dilemma.

One type of cost is the direct fiscal or financial cost of the incentives thatgovernments offer to investors, including both current costs and the present value

of commitments to provide subsidies in the future (e.g. tax holidays). Althoughconceptually easy to measure, even these direct costs are very difficult to gauge in

67 See also Graham (2000), especially pp. 63-67.

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practice because, for both legitimate and questionable reasons, the governmentsthat supply them and the investors that receive them are generally unwilling todisclose the amount of investment incentives68.

Data gathered from unofficial sources leave little doubt, however, that thedirect cost of financial and fiscal subsidies paid by governments (predominantly

sub-national governments) to attract FDI in major automobile factories rosesubstantially during the 1980s and 1990s. In countries as diverse as Brazil, India,Germany, Portugal and the United States, the direct cost of investment incentives

amounted to hundreds of thousands of dollars for each job the investment projectwas expected to create (see Table 7.2).

Table 7.2. Investment Incentives in the Automobile Industry

Date of package Host country Investor Amount per job*(US dollars)

1980early 1980s

1984mid-1980smid-1980smid-1980smid-1980searly 1990s

199219951996199619971997

United StatesUnited StatesUnited StatesUnited StatesUnited StatesUnited StatesUnited StatesUnited States

PortugalBrazilBrazilBrazil

GermanyIndia

HondaNissan

Mazda-FordGM Saturn

Mitsubishi-ChryslerToyota

Fuji-IsuzuMercedes Benz

Ford-VolkswagenVolkswagen

RenaultMercedes Benz

VolkswagenFord

4 00017 00014 00027 00035 00050 00051 000168 000265 000

54 000 – 94 000133 000340 000180 000

200 000 – 420 000* Estimated value of fiscal and financial incentives supplied by national and sub-nationalgovernments to a particular investment project, divided by the number of jobs the project wasexpected directly to create.Source: Oman (2000, Table 2.1, p. 80).

Impressive as these orders of magnitude are, it is difficult to conclude —

given reasonable assumptions about the likely long-term direct and indirectbenefits accruing to the host economy from a major new investment project — thatthe net impact on the host economy is negative, unless the factory created by the

investment shuts down within a few years (which happens more frequently thanone might expect). The cost of incentives is nonetheless very large in some cases. Itmay certainly be concluded that, in such cases, the host economy would have

derived significantly higher net benefits from FDI if it had been able to attract the

68 “Legitimate” reasons include investors’ unwillingness to disclose information that couldsignificantly benefit competitors, and governments’ desire to avoid an upward ratchet effect on thevalue of incentives demanded by investors, which is likely if each successive potential investor knowshow much the government has been willing to pay to previous investors. More questionable reasonsrelate to the danger of various forms of corrupt payments, as discussed further below.

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investment with less costly incentives.

The indirect costs of incentives are even more difficult to quantify, but they

may in many cases be significantly greater than the direct costs. One type ofindirect cost stems from the fact that incentives invariably discriminate against allthe sectors and investment projects, actual and potential, that are not targeted by

incentives. Incentives thus typically discriminate against smaller investors andagainst local investors. They also discriminate against sectors or activities inwhich the economy might develop — or might have developed — a comparative

advantage that the people responsible for targeting incentives simply did notforesee or even consider.

The largest indirect cost, however, stems from the fact that in setting up asystem to compete for FDI using discretionary fiscal and financial incentives,governments tend, over time, to develop a system of governance that lacks

transparency and, ultimately, accountability. For a developing economy, the long-term effect can be devastating. An argument can therefore be made forestablishing a clear multilateral framework of rules to limit harmful aspects of

incentive-based competition, while at the same time providing transparent, stableand predictable conditions for FDI.

7.4 Towards Constructive Rules-based Policies

In the late 1960s, a number of European investor countries began to negotiate

bilateral investment treaties (BITs) with developing countries with a view toprotecting their investment assets in these countries. According to UNCTADestimates, over 1 900 BITs were in operation as of end 2000, along with around

2 100 double taxation treaties. In the past, most of these treaties were concludedbetween developed and developing countries, but recently the number of BITsbetween developing countries has been increasing substantially (UNCTAD, 2001,

pp. 6-7).

The principal role of BITs is to make binding provisions on expropriation, the

transfer of payments and compensation for losses due to armed conflict or internaldisorder, these benefits being accorded on a national treatment or MFN basis. Inaddition, BITs usually provide for the resolution of investor-state disputes by

private institutions, such as the arbitration centres of the International Chamberof Commerce or the International Centre for the Settlement of InvestmentDisputes (ICSID) under the aegis of the World Bank. However, few BITs contain

provisions on investment-restricting measures such as performance requirements.

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The WTO agreement that deals most directly with investment matters is theAgreement on Trade-related Investment Measures (the TRIMs Agreement). As

stated in the Preamble, the TRIMs Agreement aims to “promote the expansion andprogressive liberalisation of world trade and to facilitate investment acrossinternational frontiers so as to increase the economic growth of all trading

partners, particularly developing country Members, while ensuring freecompetition”. Despite this declared intent, this Agreement is restricted in scope,being substantially related only to those aspects of FDI that affect trade in goods.

The TRIMs Agreement requires that the trade-distorting performancerequirements imposed by host governments on foreign firms be notified within 90

days of the Agreement’s coming into force and eliminated in a phased manner69.The Annex to the Agreement also provides an illustrative list of TRIMs that aredeemed inconsistent with the obligations of national treatment (Article III: 4) and

of general elimination of quantitative restrictions (Article XI: 1) enshrined in the1994 GATT. This list includes local content requirements, requirements limitingimports to the value of exports (trade-balancing requirements), foreign-exchange

balancing requirements and export requirements. In other words, the TRIMsAgreement constrains WTO members from making investment incentivesconditional on these performance requirements, though developing countries are

allowed some flexibility in implementing this provision. As such performancerequirements are often “packaged” with incentive measures, the TRIMsAgreement may indirectly limit the ability of host governments to use investment

incentives as a means of attracting FDI inflows.

A number of other trade and investment agreements concluded at the

multilateral and regional levels may potentially affect the scope and magnitude ofinvestment incentives used by host governments. These include the WTOAgreement on Subsidies and Countervailing Measures (ASCM), the General

Agreement on Trade in Services (GATS), the state aid provisions of the EuropeanUnion, the North American Free Trade Agreement and the APEC Non-bindingInvestment Principles. A recent paper issued by the OECD (2001c), however, states

that “with the exception of the EU regime on state aids, none of the aboveagreements impose direct disciplines on the granting of investment incentives” (p. 3).This paper also notes that “the fact that few if any international disputes have to

date challenged an investment incentive programme indicates both the difficulty of

69 A transition period of two years is allowed for developed countries, five years for developingcountries and seven years for the least developed countries.

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stating a successful claim under the present rules, and the political economyconstraints that complicate the development of disciplines in the area” (p. 4).

In short, owing to the prisoner’s dilemma inherent in incentive-basedcompetition, the establishment of a multilateral framework of rules to disciplinesuch measures would help to increase the collective welfare of host countries.

Unfortunately, this multilateral approach has a very long way to go. Consideringthat investment issues are highly contentious under the WTO, a second-bestoption would be a regional approach to adopting more constructive, rules-based

policies towards FDI.

New regional integration agreements (RIAs) among national governments,

and moves to deepen or strengthen existing ones, which have proliferated since themid-1980s, have proven to be effective policy instruments for attracting FDI.NAFTA, Mercosur and the deepening of European integration are all cases in point.

Their considerable power to attract FDI is not difficult to understand.

First and foremost, they tend significantly to enlarge the market that can

effectively be served by an investment in the region. In doing so, they greatlystrengthen one of the key “fundamentals” to which investors attach greatimportance in choosing an investment location. RIAs can help to improve other

fundamentals as well. In particular, governments often use them as vehicles toachieve a greater degree of internal market deregulation, or to pass regulatoryreforms, especially when resistance from powerful domestic interest groups makes

needed regulatory reform difficult to achieve at the national level. At the sametime, they can help to ensure that a necessary process of deregulation does notdegenerate into an unmanaged and destructive process of competitive

deregulation.

Second, RIAs can facilitate the co-operation among governments that may be

needed to defend standards and regulations — e.g. on the environment andworkers’ rights — because such rules can be difficult for governments individuallyto defend, or enforce, when faced with domestic pressures and the prisoner’s

dilemma nature of policy competition. RIAs can also serve to harmonise andregulate governments’ use of fiscal and financial incentives to attract FDI, as wellas contributing to greater macroeconomic and political stability in a region.

Finally, no discussion of rules-based competition for FDI, especially amonggovernments in developing countries, would be complete without mention of the

tremendous importance that some investors — especially those seeking sites for

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long-term investment in major production facilities — attach to the stability andpredictability of the operating environment of their investment sites. This is whypolitical and macroeconomic stability is included among the key “fundamentals”

noted above. While a system based on negotiated incentives to attract investorsmay appeal to many investors, as well as to some government officials, in the longrun most investors profit more from the stability, transparency and predictability

of a rules-based approach to FDI policy.

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Annex Table 7.1. FDI Policy Regimes in Latin America

Policy Measure Argentina Brazil Chile Colombia MexicoOpenness Screening No registration or prior

government approvalrequired1.

All investments must beregistered with the CentralBank of Brazil within 30days of entering thecountry. Registration is apro forma requirement,but is needed forremittance of profitsabroad, repatriation ofcapital and registration ofthe reinvestment ofprofits.

Pro forma screening bythe government foreigninvestment committee.

Investment screening hasbeen largely eliminated,and the mechanisms thatstill exist are generallyroutine and non-discriminatory. Sometypes of investments,however, are subject tospecial regimes, e.g. inthe financial, hydrocarbonand mining sectors 2.Foreign investments mustbe registered with theCentral Bank’s foreignexchange office withinthree months of thetransaction date to ensurethe right to repatriateprofits and remittancesand to access officialforeign exchange.

The 1993 investment law,which is consistent withthe investment chapter ofNAFTA, eliminated therequirement ofgovernment approval forabout 95 per cent of totalactivities. Authorisation bythe National Commissionfor Foreign Investment isrequired when theinvestment is greater than$25 million or when amajority share in aregulated sector isinvolved. If the agencydoes not respond within45 working days, theproject is deemed to beapproved.

Note:1) Exceptions to national treatment are maintained in the following sectors: real estate in border areas, air transport, shipbuilding, nuclear energy, uraniummining, and fishing (see US State Department, Country Commercial Guide, 2001).

2) In any event, the Colombian Economic and Social Policy Council (CONPES) may designate sectors of economic activity in which the government hasdiscretion on whether to admit foreign capital participation.

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Annex Table 7.1. FDI Policy Regimes in Latin America (continued)

Policy Measure Argentina Brazil Chile Colombia MexicoOpenness National

treatmentThe Constitution grantsnational treatment toforeign investors.

Foreign capitalreceives same legaltreatment as thatapplicable to nationalcapital 3.

The Constitution grantsnational treatment toforeign investors 4.

According to theprinciple of equalitygoverning foreigninvestments inColombia, foreigninvestors are subject tothe same treatment asdomestic investment.Thus, no discriminatoryconditions or treatmentmay be imposed 5.

National treatment is granted formost foreign investment.

Negativelist

No areas of economicactivity reservedexclusively to nationalcapital 6.

Foreign capitalparticipation barred orsubject to limitations inthe following sectors:media, nuclear energy,health care, ruralproperty ownership,highway freighttransport, concessionof domestic airlines,equity ownership infinancial institutionsand insurancecompanies 7.

Foreign capitalparticipation isrestricted in fishing,media, financial sector,and real estate inborder areas 8.

Foreign investment isprohibited in thedefence and nationalsecurity sector and intoxic waste disposal.Restrictions areimposed on foreignparticipation intelevision, ships’brokers, the nationalairline and shippingcompanies 9.

There are 45 activities that are notyet liberalised. Activities (a)reserved to the state (e.g.petroleum, and electricity); (b)reserved to Mexican nationals (e.g.ground transportation, professionaland technical services), and (c)subject to specific regulations (e.g.air transportation, financial sector,railways )10.

3) Art. 2 of Law 4.131/62, mentioned in http://alca-ftaa.iadb.org/eng/invest/bra~1.htm. Constitutional amendment approved in 1995 to eliminate the distinctionbetween foreign and national capital.

4) The one-year residency requirement for capital repatriation — mostly applying to portfolio investment — was abolished in March 2000. The 30 per cent reserverequirement applying to all foreign capital entering Chile (the encaje) was abolished in September 1998.

5) See “Statute of foreign investment in Colombia” in http://www.coinvertir.com/01-legal/06_estatu/1_ing.htm#2.6) Mentioned in http://alca-ftaa.iadb.org/eng/invest/arg~1.htm. Foreign firms may participate in privatisation and publicly financed R&D programmes.7) Foreign firms may participate in the privatisation process, but any foreign capital invested under the privatisation plan must remain in Brazil for at least 6

years. See www.buybrazil.org/econ.html and www.brasilemb.org/trdae/guide.html.8) Vessels fishing in the Chilean Exclusive Economic Zone must have majority Chilean ownership. Reciprocity instead of national treatment is applied to coastal

shipping trade. Foreign investors may participate in the privatisation process and enjoy the same benefits as nationals.

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Policy Measure Argentina Brazil Chile Colombia MexicoPerformancerequirements

No specific performancerequirement for FDI.

Local workerrequirements 11.

Local workerrequirements 12.

Local workerrequirement13. Localcontent requirement in theautomotive industry.

Almost all performancerequirements (exportrequirements, capitalcontrols, local content, etc.)have been eliminated,except for the automotiveindustry and for companiesapplying for in-bond industryprogrammes.Local worker requirementsexist14.

9) Generally, foreign investors may participate in privatisation of state-owned enterprises without restrictions. Colombia imposes the same investmentrestrictions on foreign investors as on national investors.

10) For a complete listing, see “Basic Guide for Foreign Investors”, National Bank of Foreign Trade(http://www.bancomext.com/Bancomext2000/publicasecciones/secciones/192/ingles.pdf).

11) In firms employing three or more persons, Brazilian nationals must constitute at least two-thirds of all employees and receive at least two-thirds of totalpayroll.

12) The labour law requires that at least 85 per cent of the employees of a particular employer must be Chilean nationals. Companies with no more than 25employees are exempt from this rule. Local content requirements in the automobile assembly sector expired in 1998; a request for extension is pending.

13) Without exemption, at least 90 per cent of a company’s labour force and 80 per cent of management must be Colombian nationals.14) There are no formal performance requirements. However, Article 29 of the Foreign Investment Law indicates the criteria the Commission will use for

evaluating requests submitted to it for consideration: a) impact on employment and worker training; b) contribution to technology; c) compliance with theenvironmental provisions in the relevant ecological ordinances; and d) in general, contribution to increasing the competitiveness of the country’s productiveplant. In deciding the outcome of a request, the Commission may not impose requirements that distort international trade. Article 7 of the Federal LabourLaw stipulates that employers in every enterprise or establishment must ensure that at least 90 per cent of employees are Mexican. Workers in technical andprofessional fields must be Mexican, except where no Mexican nationals can be found for a particular specialisation, in which case employers may hire foreignworkers in proportions not exceeding 10 per cent of the staff with that specialisation. The employer and foreign employees are obliged to train Mexicanworkers in the specialisation in question. Physicians serving enterprises must be Mexican.The provisions of this article are not applicable to directors, board members or general managers (FTAA-ALCA, Legislation for Foreign Investment Statutes inCountries in the Americas Comparative Study – Mexico).

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Policy Measure Argentina Brazil Chile Colombia MexicoIncentives Fiscal

incentivesArgentinean and foreignfirms face the same taxtreatment (33% of netprofits).

Domestic and foreignfirms investing in lessdeveloped areas receiveequal tax benefits.

Investments over$50 million may qualifyfor tax concessions.Corporate taxexemptions are availableto both domestic andforeign firms investing inless developed areas.

Tax and foreignexchange benefits areavailable to domesticand foreign investorsoperating in specialzones and producing forexport.Reinvestment ofcorporate profits inColombia for at least fiveyears grants exemptionfrom the 7% dividendincome withholding taxor remittance tax. Profitsare taxed at 35%.

Most direct taxincentives have beeneliminated. The onlysignificant federal taxincentive is accelerateddepreciation allowances.

Otherincentives

Existing incentivesmanaged by the Ministryfor the Economy apply toboth domestic andforeign firms.

Same as above 15. No special incentives forFDI.

No special incentives forFDI.

Special incentives existfor both domestic andforeign investments inpriority developmentzones and priorityindustries.

15) www.buybrazil.org/econ.html.

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Policy Measure Argentina Brazil Chile Colombia MexicoInvestmentprotection

IPR Member of WIPO. WTOlegislation on IPRratified as law in 1995 16.

Member of WIPO andsignatory of the BernConvention, ParisConvention andWashington Treaty. TheNew Industrial Propertybill concerning patentsand trademarks, whichcame into effect in May1997, satisfies theTRIPS agreement17.

Member of WIPO andsignatory of the Bernand Paris Conventions.IPR law promulgated in1991.

The common regulatorysystem for industrialproperty (trademarks andpatents) stems fromDecision 486 of theAndean CommunityCommittee, implementedby Decree 2591 of 12December 2000 andRegulatory Resolution210 of 15 January 2001.Intellectual propertyprotection (copyrights) isprovided by means ofLaw 23 of 1982, Law 44of 1993 and Decision 351of the AndeanCommunity Committeeand regulatory decrees.Colombia is a member ofWIPO and ratified theParis Convention in1996.Colombia remains on theSpecial 301 Watch List ofthe US TradeRepresentative for notproviding effectiveprotection of IPRs.

Mexico is a signatory to most majorinternational IPR conventions, aswell as NAFTA and WTO. IPRprotection is provided by theMexican Institute of IndustrialProperty Rights, established in1991, and the 1994 IntellectualProperty Law. Intellectual property isprotected by a new copyright lawpassed in 1996.

16) Patent protection is available but inadequate, especially for pharmaceuticals. However, most of Argentina’s TRIPS obligations came into force on 1 January2000. No specific law on trade secrets exists, although penalties for unauthorised revelation of secrets are applied to a limited degree under commercial law.Argentina has signed the WIPO Treaty on Integrated Circuits, but has no law dealing specifically with the protection of layout designs and semiconductors.17) The law, however, includes some compulsory licensing and local worker requirements.

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Policy Measure Argentina Brazil Chile Colombia MexicoInvestmentprotection

Disputesettlement

Domestic or internationalarbitration. Member ofICSID and MIGA.Signatory of the NewYork Convention on theRecognition andEnforcement of ForeignArbitral Awards (1989).

Not a member of ICSID,nor signatory to the NewYork Convention, butmember of MIGA.Bilateral InvestmentTreaties (BITs) allow forinternational arbitration,but foreign arbitrationawards requireconfirmation by a court ofthe country where thejudgement is renderedand the BrazilianSupreme Court.

Member of ICSID andMIGA. Signatory to theNew York Convention(1975). BITs allow forbinding internationalarbitration.

Colombia is a signatoryto the New YorkConvention (1979) and amember of ICSID andMIGA. National Law 315permits the inclusion ofan international bindingarbitration clause incontracts betweenforeign investors anddomestic partners.

Mexico is a signatory tothe New YorkConvention (1971), but isnot a member of ICSIDor MIGA. Disputes canbe addressed undereither NAFTA or WTO.

Note to Annex Table 7.1 : Most of the information contained in this table comes from the Country Commercial Guides prepared by the US Department of State,from the FTAA (http://www.alca-ftaa.org) and APEC (http://tyr.apecsec.org.sg/download/ieg) Internet sites, and from national investment promotion agencies,whose Internet sites can be recovered from http://www.ipanet.net.

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Annex Table 7.2. FDI Policy Regimes in Asia

Policy Measure China India Indonesia Malaysia Chinese TaipeiOpenness Screening Chinese authorities

attempt to guide FDItowards “encouragedindustries and priorityregions”. Allinvestments must passthrough a sequentialscreening processinvolving various levelsof government,depending on the sizeof the project1. Eachproject is evaluatedagainst officialguidelines to determinewhether it is beneficialto the development ofthe Chinese econom y2.

Foreign investment isfreely allowed in allsectors (includingservices) except incases where sectoralceilings exist3. An“automatic route” forforeign directinvestment is available.Investors are required tofile relevant documentswith the Reserve Bankof India within 30 daysafter the issue of sharesto foreign investors.Proposals that do notfulfil the conditions forautomatic approval willrequire the approval ofthe Foreign InvestmentPromotion Board, withinthe Ministry ofCommerce & Industry,or of the CabinetCommittee on ForeignInvestment (investmentin excess of$171 million).

To obtain investmentapproval, investors mustsubmit an applicationform to the Chairman ofthe InvestmentCoordinating Board(BKPM)4 . Foreigninvestments exceeding$100 million no longerrequire approval by thePresident of Indonesia,but can now beapproved by theChairman of BKPM.Starting in January2000, some provincescan accept foreigninvestment applicationsdirectly. With theimplementation ofdecentralisation, eachprovince will eventuallybe able to acceptapplications.Foreign investment inIndonesia is no longersubject to a prescribedminimum amount ofcapital.

Foreign investmentsmust be approved bythe Malaysian IndustrialDevelopment Authority(MIDA, for themanufacturing sector) orby other regulatoryagencies (non-manufacturing sector).Each project isevaluated against theguidelines set forth inthe Industrial MasterPlan and by the ForeignInvestment Committee5.Foreign equityparticipation has beengoverned by the level ofexports. A temporaryrelaxation of the strictforeign equity policywas in place during the1998-2000 period, andthe government hasextended its liberalisedtreatment of foreigninvestment until 31December 2003.Foreign equity holderswill not be required todivest or dilute theirequity holdings inprojects approved underthe above guidelines.

Application forinvestment approvals,acquisitions andmergers are screenedby the ForeignInvestment Commissionwithin the Ministry ofEconomic Affairs.Screening is routine andnon-discriminatory.Investment above$49 million andinvestment in industrieson the negative list arescreened by an inter-ministerial commission.

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Annex Table 7.2. FDI Policy Regimes in Asia (continued)

Note:1) Projects below $30 million may be approved by Special Economic Zones, open cities, provincial capitals and some other cities. Smaller cities can approve projects valued at$10 million. Projects above $30 million need approval by the Ministry of Foreign Trade and Economic Co-operation and the State Development and Planning Commission.Projects above $100 million must obtain State Council approval. After approval, foreign investors have 30 days to apply for registration. Business licences are issued by theindustry and commerce administration authorities. The date of the licence is the date of establishment of the enterprise. The approval process sets a fixed period within which theinvestment must be made; if it is not made within that period, the licence can be revoked. The licence includes a period of operation for the enterprise.Extensions must be obtained 180 days before expiration. Separations and mergers are subject to approval and registration. See Law of the People’sRepublic of China on Foreign Invested Enterprises, 12 April 1986, Art. 6, 7, 9, 10 and 20.

2) A new investment must increase foreign exchange, introduce new technology or improve skills. The investment cannot be approved if it uses technologythat is already available in the People’s Republic or if the existing production capacity can already satisfy domestic demand.http://tyr.apecsec.org.sg/download/ieg/.

3) Ceilings on foreign equity ownership exist in several sectors (banking/insurance, civil aviation and airport infrastructure, telecommunications, petroleum,drugs and pharmaceuticals, trading). For a complete list, see the Indian Investment Centre website athttp://iic.nic.in/vsiic/iic3_a.htm#Investment%20Policy.

4) The new investor must apply for an initial investment approval, which serves as a temporary operating licence. The process is completed in 10-20 workingdays. Once the foreign firm starts production, it must apply for a permanent business licence. The business licence is granted for a period of 30 years fromthe commencement of commercial operation and may be renewed.

5) Detailed guidelines for project evaluation exist. Among other criteria, project approval depends on export orientation, local equity participation, source offinancing and the potential for technological diffusion. Seehttp://www.state.gov/www/about_state/business/com_guides/2001/eap/malaysia_ccg2001.pdf.

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Policy Measure China India Indonesia Malaysia Chinese TaipeiOpenness National

treatmentNational treatment isextended, on a reciprocalbasis, to contractingparties of internationaltreaties to which China isa signatory. In practice,however, nationaltreatment is denied inalmost all service andmost industrial sectors.In the context of itsaccession to the WTO,China has committed togranting unconditionalnational treatment underthe 1994 GATT.

In the majority of casesforeign investment is notgranted nationaltreatment.

National treatment is notgranted to most foreigninvestment6. Under theASEAN Investment AreaFramework Agreement(AIA), Indonesia iscommitted to extendingnational treatmentgradually, first to ASEANinvestors and then to allinvestors, subject to themember economy’sspecific reservations andexceptions 7.

Foreign direct investorsestablished in Malaysiaare generally accordednational treatment in allbut equity limits.Furthermore, criteria forproject approval areapplied in a non-discriminatory manner,except in instanceswhere local and foreignfirms propose identicalprojects.Malaysia is a signatory tothe AIA FrameworkAgreement.

Foreign firms aregenerally accordednational treatment.

6) A revised Foreign Capital Investment Law is being prepared and may come into effect as early as 2002. This law would provide an appropriate legal frameworkfor investment based on equal treatment of investors; protection against expropriation, confiscation or requisition of investments and unilateral alteration ortermination of contracts; freedom to repatriate foreign investment capital and net proceeds thereon; and access to impartial, quick and effective mechanisms forthe resolution of commercial and other investment disputes.

7) The objective of AIA is to build a liberal, transparent and attractive ASEAN Investment Area in order to promote investment into ASEAN from both ASEANand non-ASEAN sources. It is expected that under the AIA Agreement member countries will “immediately open” all industries and “immediately grant”national treatment. However, Article 7 of the Agreement also provides that each member country may, depending on its specific conditions, draw up aTemporary Exclusion List and Sensitive List, composed of any industries that the country cannot open or investment-related measures for which it cannotgrant national treatment status to ASEAN investors. The salient features of the AIA are: extending national treatment to ASEAN investors by 2010 and allother investors by 2020; opening all industries to ASEAN investors by 2010 and all other investors by 2020; exclusion allowed through the Temporary ExclusionList (TEL) to be phased out by 2010 and the Sensitive List (SL) to be reviewed by 2003; granting ASEAN most-favoured-nation treatment for ASEAN investors.

105


Policy Measure China India Indonesia Malaysia Chinese TaipeiOpenness Negative list The Provisional

Regulations of Guidanceof Foreign Investmentrestrict FDI that is notbeneficial to thedevelopment of theChinese economy andprohibit FDI thatjeopardises nationalsecurity or the social andpublic interest.Foreign investment is notallowed in manytelecommunicationservices, as well as thenews media and televisionsectors. Access to somesectors is conditional onestablishing a jointventure where theChinese partner has theleading position (e.g.construction, aviationindustry, automobileindustry, foreign trade).

Defence and strategicindustries are closed toforeign investment, as wellas agriculture, rail andpostal services, housingand real estate.

According to the 2000negative list, there aresome sectors whereinvestment is prohibited orreserved to thegovernment (includingsectors that may involvepublic health and safetyhazards), some sectorsclosed to foreigninvestment and somesectors where foreigninvestors must establish ajoint venture in which atleast 5% of the issuedcapital is held by domesticinvestors 8.

With the exception ofactivities designated in aspecific negative orexclusion list, all newprojects in manufacturing,including investments forexpansion anddiversification, areexempted from bothequity and exportconditions. Project ownerscan hold 100% of theequity, and need not meetany export requirement todo so 9.Foreign equity ownershipis still limited incommercial banking (30%of equity), insurancecompanies (51%),telecommunications(61%) and shippingcompanies (70%), eventhough the limits havebeen loosened.

Foreign investment isprohibited in agriculture,forestry, fishing,pesticides, explosives,firearms, militaryequipment, postalservices and savingsinstitutions, and wirelessbroadcasting.Many sectors have beenremoved from thenegative list, such aspower generation,transmission anddistribution, real estatedevelopment,transportation.Foreign ownershipceilings (usually 50%) stillexist for sectors such astelecommunications,airlines, electrical powerand transportation.

8) Sectors closed to foreign investment include radio, television, Internet and print media, the film industry (film making, film technical services, film export andimport business, film distribution and theatre operation and/or viewing services), trading and transportation. Sectors open to joint ventures include the building andoperation of ports; electricity production, transmission and distribution; shipping; processing and provision of clean water to the public; public railway system;nuclear power generation; medical services; telecommunications and air transport. For details see http://www.usembassyjakarta.org/econ/investment0800.html.

9) Exclusion List of Activities: paper packaging, plastic packaging (bottles, films, sheets and bags), plastic injection moulding components, metal stamping, metalfabrication and electroplating, wire harness, printing, steel service centre.

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Policy Measure China India Indonesia Malaysia Chinese TaipeiOpenness Performance

requirementsExport requirements:although not formallyrequired, they are includedin many contracts. Localcontent: localisation ofproduction is stronglyencouraged. Foreigninvestors are often askedgradually to increase thepercentage of localcontent. Technologytransfer: although notformally required,technology transfer isincluded in manycontracts and encouragedby means of incentives.Local workerrequirements: rules forhiring Chinese nationalsdepend on the type ofestablishment.

Local workerrequirements: No localworker requirements.Restrictions on employingforeign technicians andmanagers have beeneliminated. Otherrequirements: Localcontent requirement,export obligations andforeign-exchangebalancing apply to allforeign automobilemanufacturing investmentin India.

In June 1994, thegovernment dropped initialforeign equity requirementsand sharply reduceddivestiture requirements.Indonesian law provides forboth 100% foreign-ownedinvestment projects andjoint ventures with aminimum Indonesian equitystake of 5%. Foreignshareholders are no longerrequired to reduce theirholdings to a minorityposition at some time in thefuture. There is arequirement that within 15years of establishment, a100% foreign shareholdershall sell at least a nominalpercentage to anIndonesian citizen or entity.Local content and exportrequirements: none. Localworker requirement: Acompany may hireforeigners only forspecifically designatedpositions. Employers musthave labour trainingprogrammes aimed atreplacing foreign workerswith Indonesian. Foreigninvestors must contribute tothe training anddevelopment of thedomestic labour force.

Divestiture requirementsin manufacturing havebeen relaxed during thelast two years, but theystill exist in some sectors,such astelecommunications(foreign equity must bereduced to 49% after fiveyears). Joint venture andlocal worker requirement:the government oftenrequires foreign investorsto share ownership withlocal partners (30% ofequity) and hire Malaysianworkers, in proportionsreflecting Malaysia’sethnic composition.Foreign workers may beemployed only in theconstruction, plantation,service (domesticservants, hotels, trainingpersonnel) andmanufacturing sectors. Inaddition, certain “keyposts” may bepermanently filled byforeigners. To ensure thatforeign labour is employedonly when necessary, anannual levy on foreignworkers is imposed.

Like domestic firms,foreign companies mustlocate in designatedzones and are subject torestrictions on the numberof foreign employees thatcan be hired. To obtaininvestment authorisation,it is not necessary to meettechnology transferrequirements or employ aminimum number of localworkers. Firms in EPZsare required to export allthey produce, althoughthey may sell on thedomestic market afterpaying import duties.Local contentrequirements remain inplace only in theautomotive industry.

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Policy Measure China India Indonesia Malaysia Chinese TaipeiFiscalincentives

China has long grantedrebates and other taxbenefits to foreigninvestors. The taxincentive system iscomplicated, however,mainly because ofoverlapping of central,provincial and localgovernment regulations.

No income tax on profitsderived from export ofgoods. Completeexemption from customsduty on industrial inputsand corporate tax holidayfor five years for 100%export-oriented firms andfirms in ExportProcessing Zones.

Fiscal incentives areavailable to bothdomestic and foreigninvestors. Specialinvestment incentives aregranted on a case-by-case basis by BKPM.Special tax facilities aredesignated for investorsentering designatedpioneer industries 10.

Fiscal incentives areavailable to bothdomestic and foreigninvestors and are usuallylinked to performancecriteria, such as exporttargets, local content andtechnology transfer.

Accelerated depreciationallowances and taxcredits are offered tofirms introducing newtechnologies or locatingin less developed areas.The five-year tax holidayfor new investment wasre-introduced in 1995.

Incentives

Otherincentives

Many incentives areavailable to investors inSpecial Economic Zones,as well as in lessdeveloped regions.Foreign investors mayhave to negotiateincentives and benefitsdirectly with the relevantauthorities. Someincentives and benefitsmay not be conferredautomatically.

Various incentives areavailable for exportingfirms and firms located inthe Multimedia SuperCorridor (MSC). Inparticular, firms with MSCstatus face no restrictionson recruitment ofexpatriates, are exemptfrom all capital controlsand can apply forgovernment funding forR&D. Non-fiscal exportincentives consist of anexport credit refinancingfacility, an infrastructureallowance and variousinvestment allowances 11.

10) The tax holiday system and other facilities for new investors are under review and may be abolished under the IMF-supported reform programme.11) See http://www.mida.gov.my/policy/chapter3.html.

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Policy Measure China India Indonesia Malaysia Chinese TaipeiInvestmentprotection

IPR China is a member ofWIPO and a signatory tomost conventions onindustrial and intellectualproperty rights.Furthermore, China hascommitted to fullcompliance with theTRIPS agreement uponaccession to the WTO.Nevertheless,implementation of IPRprotection remainsproblematic.

India is a member ofWIPO and a signatory tomost conventions onindustrial and intellectualproperty rights (though notthe Paris Convention).The new Trademark Billpassed in 1999 raisedtrademark protection tointernational standards.Enforcement ofintellectual property rightsis improving but still weak.Patent protection is weak,since no patent can begranted for a new productthat can be used as a foodor drug 12. As a signatoryto the WTO TRIPSagreement, India iscommitted to introducing acomprehensive system ofproduct patents no laterthan 2005.

Indonesia became amember of WIPO and asignatory to the majorinternational conventionsdealing with IPR only in1997. Until 2001,Indonesia did not havelaws on protection ofindustrial designs, layoutdesigns of integratedcircuits, trade secrets andplant varieties 13. Therehas been someimprovement, but effectiveenforcement of IPRs isstill extremely difficult dueto the ineffectiveness ofIndonesia's judicialsystem and somelegislative drawbacks 14.

On 30 April 2001, the USTrade Representativedowngraded Indonesiafrom Watch List to PriorityWatch List under theSpecial 301 provision.

Malaysia is a member ofWIPO and a signatory tothe Bern and ParisConventions. Legislationconcerning protection ofIPRs is adequate, havingbeen amended in 2000 tocomply with the WTOTRIPS Agreement.Enforcement of copyrightlaws is improving,although piracy rates forsoftware and music andvideo discs are still veryhigh 15.

In April 2001, the USTrade Representativedecided to keep Malaysiaon the Special 301 PriorityWatch List for its failure toobtain substantialreductions in theproduction and export ofpirated optical discs.

Chinese Taipei is not amember of WIPO.Copyright, patent andtrademark laws have beenamended recently toconform to TRIPSstandards, but only thetrademark law and certainprovisions of the copyrightlaw have beenimplemented. Theamended part of thepatent law will not go intoeffect until Chinese Taipeiaccedes to the WTO.

Taiwan is on the USSpecial 301 Watch List.

12) Processes for making such products can be patented, but the patent term is limited to five years after the patent has been granted.13) Five international conventions signed in 1997: Paris Convention for the Protection of Industrial Property, Patent Co-operation Treaty and Regulations under

the PCT, Trade Marks Law Treaty, Bern Convention for the Protection of Literary and Artistic Work, WIPO Copyright Treaty (Presidential Decrees Nos.16-19 of 1997). Three new laws, namely the Law on Industrial Design, Law on Layout Design of Integrated Circuits, and Law on Trade Secrets, were enactedin December 2000. Furthermore, two revised laws were enacted in August 2001, the Patent Law and the Trademark Law. In the meantime, the revised draftof the Copyright Law is still under consideration by the Parliament. In January 2001, the Appeal Commissions on Patents and Trademarks were instituted(http://www3.itu.int/MISSIONS/Indonesia/State.htm).

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Policy Measure China India Indonesia Malaysia Chinese TaipeiInvestmentprotection

Disputesettlement

Member of ICSID andsignatory to the NewYork Convention (1987).Member of MIGA.Chinese authorities,however, preferarbitration throughnational agencies, suchas the ChinaInternational Economicand Trade ArbitrationCommission.

India is a signatory tothe New YorkConvention (1960), butis not a member ofICSID. A new Arbitrationand Conciliation Actwas approved in 1996on the basis of the UNCITRAL model law.

Member of ICSID andMIGA and a signatory tothe New YorkConvention (1982).However, no lawrequires Indonesiancourts to enforce thejudgements of non-Indonesian courts, andthe court system doesnot provide effectiverecourse for resolvingcommercial disputes.

Malaysia is a member ofICSID and MIGA and asignatory to the NewYork Convention (1986).The government hasalso set up the KualaLumpur RegionalCentre for Arbitrationunder the auspices ofthe Asian-African LegalConsultative Committeeto offer internationalarbitration, mediationand conciliation fortrade disputes.

Chinese Taipei is not amember of ICSID orMIGA, nor a signatory tothe New YorkConvention. Disputesare usually resolvedaccording to domesticlaws and regulations.

Note to Annex Table 7.2 : Most of the information contained in this table comes from the Country Commercial Guides prepared by the US Department of State,from the ASEAN (http://www.aseansec.org) and APEC Internet sites (http://tyr.apecsec.org.sg/download/ieg), and from national Investment Promotion Agencies,whose Internet sites can be recovered from http://www.ipanet.net.

14) The amended Patent Law, for instance, states that products and production processes are patentable for a period of 20 years commencing from the filing of thepatent application, but, at the same time, allows for compulsory licensing and limits patent protection to patents that are “implemented” in Indonesia. Inpractice, this means that patented products must be manufactured in Indonesia to receive patent protection. The industry estimates the levels of music andbusiness software piracy at 87 per cent, motion picture piracy at 90 per cent and game software piracy at 99 per cent(http://www.usembassyjakarta.org/econ/301review.html).

15) Malaysia’s production capacity for CDs far exceeds local demand plus legitimate exports. The Optical Disc Act, which became effective on 15 September 2000,gives the government greater enforcement powers and allows for stiffer penalties (including jail sentences) for the production and export of pirated optical media.According to the industry, software piracy rates in Malaysia fell from 71 per cent in 1999 to 66 per cent in 2000 (http://usembassymalaysia.org.my/ccg-2002.html).

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Chapter Ⅷ Summary and Conclusions

This study reviews and discusses recent empirical research on keydevelopment issues related to foreign direct investment (FDI). The literaturereview focuses on five main areas: the FDI-growth nexus; FDI-trade linkages; FDI

and technology transfer; FDI, privatisation and corporate governance; and host-government policies for attracting FDI. The study also presents a statisticaloverview of trends in FDI flows from the global and regional perspectives. The aim

of the study is to advance the policy debate about the role FDI can play insustaining economic and social development in host developing countries. Themain issues and policy lessons may be summarised as follows.

Much of the FDI flowing into developing countries in the 1970s through themid-1980s was attracted by the availability of natural resources. This traditional

form of FDI has different implications for growth and development in hosteconomies than FDI in manufacturing and services. This study focuses on thelatter type, which has been one of the defining characteristics of the world economy

over the last 20 years.

The period since the mid-1980s, and particularly since 1993, has seen rapid

expansion of global FDI flows: outflows of FDI world-wide increased more thanfivefold, from just over $200 billion in 1992 to $1 150 billion in 2000. Much of thissurge in FDI flows is accounted for by cross-border mergers and acquisitions

(M&As) among OECD countries, triggered by policy initiatives aimed at deepeningregional integration, such as the implementation of the EU’s Single MarketProgramme and the creation of NAFTA. Among non-OECD countries, the region

comprising Latin America and the Caribbean, particularly Mercosur, has alsoembraced cross-border M&As as the principal mode of FDI inflows in the context oflarge-scale privatisation programmes, including privatisation of public utilities. In

contrast, ASEAN and South Asia began to jump on the “M&A bandwagon” morerecently, in the aftermath of the 1997-98 financial crisis (see Table 2.3).

The experience of the 1990s highlights two other important developments inthe regional pattern of FDI. The first is the emergence of the United States as theworld’s largest net recipient of FDI. At the beginning of the decade, the United

States was the second largest source country of FDI on a net basis (outflows minusinflows), after Japan. Several European countries have continued to play adominant role as net suppliers of FDI, but Japan’s share in the supply of FDI

diminished considerably during this period. The second important development is

111

the rapid expansion of FDI inflows to several developing and emerging economies,among which China has been by far the largest recipient (see Chapter Ⅱ).

The global surge in FDI over the last decade has reinforced the alreadyimportant role played by multinational enterprises (MNEs) in host countries. Asmeasured by several indicators, such as industrial production, employment and

foreign trade, MNE affiliates have become significant players in many OECDcountries, with the notable exception of Japan (see Table 2.1). At the same time,the increased presence of foreign affiliates has sparked renewed interest among

policymakers as to what specific contribution FDI can make to the long-termdevelopment of the host country. The answer to this question seems to be lesscontroversial in theory than in practice. Theory suggests that, by providing a

channel for knowledge acquisition and dissemination, FDI can act as an engine ofgrowth for the host economy; but the question has yet to be answered empirically.The literature on the development dimension of FDI is very large, and still growing.

Where do we stand today?

The vast majority of existing empirical studies based on macroeconomic data

indicate that FDI does make a positive contribution to both income growth andfactor productivity in host countries. FDI tends to “crowd in” domestic investment,as the creation of complementary activities outweighs the displacement of

domestic competitors. Similarly, in the North-South context the relationshipbetween FDI and trade is more one of complementarity than of substitution, owingto backward and forward linkages. Many studies, however, suggest that host

countries cannot capture the full benefits associated with FDI until they reach acertain threshold in terms of educational attainment, provision of infrastructureservices, local technological capabilities or the development of local financial

markets. This “threshold externalities” argument highlights the complex nature ofinteractions between FDI and growth in the host country; these interactions workthrough various channels, which require further analysis based on firm-level or

plant-level data (see Chapters Ⅲ and Ⅳ).

The results of recent empirical studies using microeconomic data suggest that

the “spillover” effect of FDI on the productivity growth of local firms does not occurautomatically. The estimated magnitude of technological spillovers through FDIdepends crucially on various host-country and firm-level characteristics, such as

the relative and absolute absorption capacities of individual host countries andfirms. Detailed analysis on the nature of technological spillovers is often hamperedby the extreme data requirements of such studies. Nonetheless, one conclusion

emerging from the results of several country case studies — on Italy, Mexico and

112

Uruguay, for example — is that the existence of large technological gaps in a lesscompetitive market environment tends to reduce the probability of technologicalspillovers from MNE affiliates to local firms (see Chapter Ⅴ).

As noted above, cross-border M&As (as opposed to greenfield investment)played a central role in the FDI boom of the 1990s. Privatisation of state-owned

enterprises has provided a major channel for FDI inflows not only in EasternEurope and the former USSR but also in Latin America. Since the 1997-98financial crisis, a number of Asian countries have begun to implement ambitious

privatisation programmes in the utilities sector, in order to consolidate publicfinances and revive their economies. For many governments in the region, however,privatisation and foreign participation in such programmes remain politically

sensitive issues.

An assessment of privatisation policy in both OECD and developing countries

indicates that, on balance, privatisation has increased consumer welfare, but thatthe degree of success depends crucially on the post-privatisation market structureshaped by the new regulatory system that is established. In other words,

weaknesses in the regulatory environment tend to reduce the benefits ofprivatisation. Active participation by foreign firms can also be seen as key tosuccessful privatisation programmes, as in the case of Brazil. Nonetheless,

regulatory agencies still face substantial future challenges (see Chapter Ⅵ).

The above discussions all point to the importance of host-government policies

for attracting FDI. Conceptually, host-government policies fall into two broadcategories — incentive-based and rules-based measures — although thisdistinction is not always clear in practice. An important point concerning of host-

government policies is that the use of discretionary, targeted fiscal and financialsubsidies to attract investors is ineffective as long as economic and political“fundamentals” are not satisfied. Moreover, these incentive-based measures are

too costly (and even wasteful) for developing countries facing severe resourceconstraints. Clearly, there is a need for more constructive, rules-based measuresthat can help in creating the sound business environment that firms need to make

long-term investments, including the development of local skills and technologicalcapabilities.

In this context, a comparative survey was conducted with respect to foreigninvestment regimes in ten host economies in Asia and Latin America. The resultsindicate that legal and policy frameworks for foreign investment appear to be more

open in Latin America than in Asia, despite the considerable efforts made by Asian

113

countries to liberalise FDI policy following the 1997-98 financial crisis. There arealso substantial differences among these Asian countries in terms of control overforeign investors at the entry phase and the use of negative lists. Moreover,

protection of intellectual property rights (IPRs) differs significantly in both scopeand magnitude across countries. This is considered a key feature of the foreigninvestment regime in the host country, as the IPR issue has an important

influence on the magnitude and quality of technology transfer from home to hostcountries (see Chapter Ⅶ).

The study concludes by stating that host-government polices should attachgreater importance to the stability and predictability of the local businessenvironment in which foreign firms operate. To this end, the establishment of a

multilateral framework of rules to discipline incentive-based competition wouldhelp to increase the collective welfare of host countries. Unfortunately, thismultilateral approach has a very long way to go. Considering that investment

issues remain very contentious under the WTO, a second-best option for hostgovernments would be a regional approach to adopting more constructive, rules-based policies towards FDI. The commitment to creating the ASEAN Investment

Area (AIA) is a case in point. The evolution of AIA and other regional approaches(Mercosur, FTAA, etc.) in the coming years will have important implications forfuture multilateral negotiations on trade and investment issues under the WTO.

114

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JAPAN BANK FOR INTERNATIONAL COOPERATION (JBIC)

http://www.jbic.go.jp/

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Overseas Network

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JBICI Research Paper1

1. Issues of Sustainable Economic Growth from the Perspective of the Four East Asian Countries,December 1999

2. Organizational Capacity of Executing Agencies in the Developing Countries: Case Studies on

Bangladesh, Thailand and Indonesia, December 19993. Urban Development and Housing Sector in Viet Nam, December 1999

4. Urban Public Transportation in Viet Nam: Improving Regulatory Framework, December 1999*

5. Current Situation of Rice Distribution System in Indonesia, December 19992

6. Energy Balance Simulations to 2010 for China and Japan, March 2000

7. Rural Enterprises Finance: A Case Study of the Bank for Agriculture and Agricultural

Cooperatives (BAAC) in Thailand, November 20003

8-1. Issues of Sustainable Development in Asian Countries: Focused on SMIs in Thailand, December

2000

8-2. Issues of Sustainable Development in Asian Countries: Focused on SMIs in Malaysia, December2000

9. Policy Issues and Institutional Reform in Road Sector in Developing Countries, February 20014

10. Public Expenditure Management in Developing Countries, March 200111. INDIA: Fiscal Reforms and Public Expenditure Management, August 2001

12. Cash Crop Distribution System in the Philippines - Issues and Measures to Address Them –,

March 200213. MERCOSUR Experience In Regional Freight Transport Development, March 2002

14. Regional Cooperation for Infrastructure Development in Central and Eastern Europe, March

20025

15. Foreign Direct Investment and Development : Where Do We Stand?, June 2002

*No.1~No.14 were published as ‘JBIC Research Paper Series’.

JBIC Institute,

Japan Bank for International Cooperation4-1, Ohtemachi 1-chome, Chiyoda-ku, Tokyo 100-8144, JapanTel: 03-5218-9720, Fax: 03-5218-9846 (Planning and Coordination Division)Internet: http://www.jbic.go.jp/

1 Full texts can be downloaded from JBIC homepage.2 In Japanese only. English summary can be downloaded from JBIC homepage.3 In Japanese only4 In Japanese only5 In Japanese only

foreign direct investment and development: where do we stand?

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