Strengthening policies on direct investment

Improving the environment for direct investment
The contribution made to development by direct investment depends significantly on the policy framework in which it takes place. Countries that have received the largest amount of direct investment tend to be those with large internal markets and import-substituting strategies, these also being the countries whose prices have been most distorted and where there are commonly complaints about the development contribution of direct investment. Where a more open development strategy has been followed, countries have had fewer problems with direct investment. Such a strategy makes production for domestic and export markets equally attractive and usually requires that market prices reflect relative scarcities. In these countries, governments have tended to lower tariffs and to allow real interest rates to be positive. This has resulted in the direct investment that has taken place being more closely geared to the country's comparative advantage.

Developing country policies and institutions for dealing with direct investment include:

1. Investment incentives, which are usually designed either to enhance foreign firms' revenue or to reduce their costs. Revenue-enhancing incentives include import tariffs or quotas on the product concerned, tax breaks and various kinds of preferential treatment; tariffs and other forms of protection covering products to be sold on the local market have proved the most influential. Incentives which reduce costs include reduced tariffs on imports and exemption from tax on inputs. The nature of the incentives offered will depend on the kind of investment wanted and on competition from other countries for that investment. It appears that the greater the complexity of incentives and the more frequently they are altered the less effective they become, but the impact of specific incentives for direct investment is uncertain. Although business executives tend to ignore or downplay the influence of incentives in their decisions on where to invest, a study by IFC suggests that, other things being equal, incentives can influence the investment decision.

2. Services and infrastructure provided for foreign investors.

3. A variety of restrictions on the way foreign companies can operate, which can discourage investment. Some countries reserve key industries for local (often state-owned) enterprises. Again, foreign investors may be allowed to hold only a minority stake in a company, unless the industry is defined as "high priority" or the production is mainly for export. Some countries require foreign companies to dilute ownership and control gradually through the sale of shares to residents. Many developing countries restrict remittance of interest and dividends - a major disincentive to foreign companies and one which encouraged practices such as the manipulation of transfer pricing. Developing countries may also stipulate performance requirements, such as the export of a minimum proportion of output or the use a fixed amount of local components or labour. Some countries limit the amount of local borrowing permitted to foreign investors. The IFC study showed that companies tend to take these requirements into consideration in choosing where to locate.

Specific incentives and regulations are less significant in attracting direct investment than a country's general economic and political climate and its financial and exchange rate policies. Countries in Africa and the Caribbean which have small domestic markets and limited natural resources have not attracted much direct investment despite offering substantial incentives to potential investors. However, several countries with the potential to obtain direct investment for import-substitution purposes have had only modest success because they impose restrictions and performance requirements on foreign companies. By contrast, the export-oriented development policies of some of the newly industrializing countries have attracted considerable inflows without offering significant incentives. Although the overall economic climate is of first importance, where an investment is actually made may depend on policies for a specific sector or industry.

With respect to the investing country, it is again the general economic policies of the industrial countries that most effect the amount of direct investment going abroad. Foreign investment is more attractive if there are low rates of economic growth and high production costs at home. Investment in developing countries is discouraged when the home country encourages and protects its production, when if provides direct or indirect subsidies to ailing industries which might otherwise have considered investing in developing countries or when it places restrictions on trade flows. Generous concessions offered by industrial countries to attract investment from abroad can compete directly with the incentives offered by developing countries, although most such concessions are directed toward specific, high-technology industries.

Policy initiatives in industrial countries can have a positive effect, for example when governments and trade bodies circulate information about investment opportunities, negotiate procedures for settling disputes over investment with governments of developing countries and ensure that tax laws make it attractive for individuals to work abroad in a multinational company. The most powerful stimulus of all is a liberal trade policy, since companies can then manufacture abroad to produce for industrial-country markets.

Long-term investment in plant and machinery exposes the investing company to political risk, whether expropriation, blocked currency, war, revolution or insurrection. Many developing countries have passed laws protecting investors against expropriation, some having embodied such protection in their constitution. In addition, governments in industrial and developing countries have concluded bilateral treaties on investment protection, which cover, among other things, transfer and expropriation risks; and a number of (mainly industrial) countries have set up investment guarantee schemes offering guarantees to companies and individuals from each guaranteeing country against political risks abroad. These measures are all intended to reassure actual or potential investors, although they differ appreciably in their terms and conditions, scope of coverage and administrative practices.

This strategy features in the framework of Agenda 21 as formulated at UNCED (Rio de Janeiro, 1992), now coordinated by the United Nations Commission on Sustainable Development and implemented through national and local authorities.

What is good policy for domestic investors is also good for foreign investors.
Constrained by:
Limiting foreign investment
Type Classification:
D: Detailed strategies
Related UN Sustainable Development Goals:
GOAL 16: Peace and Justice Strong Institutions