How can we maximize the benefits of FDI?

This article was originally published on The World Bank’s Private Sector Development blog.

For many decades, academia and policy making has debated about the role of Foreign Direct Investment (FDI) in development. Such question has been very difficult to elucidate, not only because the discussion has being colored by many ideological dogmas, but also because the very fundamental characteristics of cross border investment have evolved over time. Indeed, over the last five decades, the paradigm of FDI has changed significantly. Traditionally FDI has been visualized as a flow of capital, flowing from “North” to “South” by big multinational enterprises (MNEs) from industrial countries investing in developing countries, traditionally aiming to exploit natural resources in the latter or to substitute trade as a means to serve domestic consumption markets. Such paradigm has changed significantly.

Today, FDI is not only about capital, but also –and more important– about technology and know-how, it no longer flows from “North” to “South”, but also from  “South” to “South” and from “South” to “North”. Further, FDI is no longer a substitute of trade, but quite the opposite. Today FDI has become part of the process of international production, by which investors locate in one country to produce a good or a service that is part of a broader global value chain (GVC). Investors then, have become traders and vice-versa. Moreover, FDI is now not only carried out by only big MNEs, but also from relatively smaller firms from developing countries that are investing in countries beyond their home countries. Last but not least, cross-border investment is no longer only about portfolio investment and FDI. International patterns of production are leading to new forms of cross-border investment, in which foreign investors share their intangible assets such as know-how or brands in conjunction with local capital or tangible assets of domestic investors. This is the case of non-equity modes of investment (NEMs) –such as franchises, outsourcing, management contracts, contract farming or manufacturing.
Challenges in an evolving context: how to maximize the benefits of cross-border investment?

Some countries attract large quantities of foreign investment and never move up the value chain.  In order to maximize the development impacts of foreign investment, a suitable investment policy framework is needed.

The difficulty starts when decision-makers try to identify what “investment policy” is, or should be. A huge range of stakeholders, problems, institutions, legal instruments, and administrative tools are captured in that concept. Countries get lost. Even if policy-makers can identify a destination, it can be difficult to know where to start, to know which concrete actions will have the most impact.
Investment policy encompasses a huge range of issues, and for a state that hopes to reap the benefits of foreign investment, it can be difficult to know where to start. A common mistake is that countries create investment policies to react to the challenges posed by the type of investment they are already receiving. Instead, a state also needs to identify the opportunities to receive greater benefits from existing investments, and consider what other types of investment the country needs in order to develop. Many developing country governments face difficulties in investment policy formulation, coordination and implementation, thus undermining their competitiveness and compromising the ability to attract and maximize the benefits of investment.

What insights does recent FDI policy analysis offer?

As a first stage in tackling these challenges, a recent working paper, “Impacts of Investment Policy in the Global Modern Economy: A Review of Literature” by Roberto Echandi, Jana Krajcovicova and Christine Zhenwei Qiang examined econometric and case-study evidence about how good investment policies can help maximize the potential benefits of foreign direct investment (FDI). That includes insights about transforming domestic productive sectors by increasing participation in global value chains.

Two fundamental observations can be drawn from the literature:

With adequate policies, FDI can provide significant economic and social benefits to host countries. For example, FDI can help create higher-skilled and better-paid jobs, promote the transfer of knowledge, raise productivity, and diversify and upgrade the value‐added component of exports—all of which affect a country’s ability to integrate with global value chains. However, such benefits are not automatic. Designing and implementing appropriate investment policies is required if potential of cross border investment is to be maximized. Different contexts call for different policy mixes. The question is then how can governments count with a framework   Specifying policy interventions responding to the respective country and investment contexts may be required.

There is a need to come up with a framework sophisticated enough to differentiate different types of investment and at the same time be simple enough to be practical for policy making. Although a substantial body of literature on the various impacts of investment policy and FDI exists, findings are derived from either an extremely case‐specific research focus –such as an analysis of FDI experiences in one particular country and sector during a given period– or an overly broad focus  –as if FDI were a homogenous phenomenon. Very few studies differentiate within types of FDI in their analysis. The resulting gap makes it difficult for policymakers to organize the multiple, complex variables affecting a country’s ability to maximize investment benefits.

Could research become more “digestible” for policymakers?

The paper suggests applying a logical framework that takes into account investor characteristics and motives in a more systematic manner.  In fact, an FDI typology based on the key motivations of investors when choosing locations – whether they are seeking natural resources, serving domestic markets, locate segments of international production processes, or seeking to acquire strategic assets – has already been applied by academics –see for example, a book by John H. Dunning and Sarianna M. Lundan — and has proven to be effective in guiding strategic policy discussions on national investment agendas led by World Bank Group teams in many countries.

A few studies cited in the working paper already adopt the FDI-motive-based approach, but a systematic application of it would allow to design effective reform packages around distinct investor characteristics. Future research could also continue refining the methodological approach to account for the specifics of sectors and activities undertaken by various actors in the global value chains.

Governments are reforming, and they require knowledge that is both cogent and applicable to their specific contexts. While abundant and useful literature has been produced so far, tailoring research to the challenges of investment policy in practice will increase its relevance for countries seeking to enact reforms.
Publication does not imply endorsement of views by the World Economic Forum.

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Authors: Christine Zhenwei Qiang is Practice Manager for Investment Climate of the World Bank Group’s Trade & Competitiveness Global Practice. Roberto Echandi is the Global Investment Policy Lead of the Investment Climate Unit of the World Bank Group’s Trade & Competitiveness Global Practice. Jana Krajcovicova is an Investment Policy Specialist in the Investment Policy and Promotion team of the World Bank Group’s Trade and Competitiveness Global Practice in Vienna.

Image: People pass the Bank of England in the City of London January 16, 2014.  REUTERS/Luke MacGregor.