Challenges of Foreign Investment in Promoting Economic Growth

Group Four

Journal of International Economics

Volume 45, Issue 1, 1 June 1998, Pages 115-135

Author links open overlay panelE. Borensztein a, J. De Gregorio b, J-W. Lee c

Abstract

This paper examines the performance, promotion, and prospects for foreign direct investment (FDI) in Africa. Factors such as political and macroeconomic instability, low growth, weak infrastructure, poor governance, inhospitable regulatory environments, and ill-conceived investment promotion strategies, are identified as responsible for the poor FDI record of the region. The paper stresses the need for more trade and investment relations between Africa and Asia. It also argues that countries in the region should pay more attention to the improvement of relations with existing investors and offer them incentives to assist in marketing domestic investment opportunities to potential foreign investors. Finally, the paper argues that the current wave of globalization sweeping through the world has intensified the competition for FDI among developing countries. Consequently, concerted efforts are needed at the national, regional, and international levels in order to attract significant investment flows to Africa and improve the prospects for sustained growth and development.

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Introduction

Forreign Direct Investment (FDI) is considered as one of the vital ingredients for overall development process of a developing country like Bangladesh. Industrial development is an important prerequisite for economic growth of a developing country. Bangladesh is basically a country of agrarian economy. For her economic development, industrial economy is imperative. So Bangladesh is gradually moving from agrarian economy to industrial economy. In the age of globalization, it has become a burning issue to exchange views, ideas, capital and human resources. Government of Bangladesh is trying to create a favorable investment environment through introducing economic policies, incentives for investors, promoting privatization and so on. Therefore, the contribution of FDI is necessary in the enhancement of a country’s economic growth. Researchers have marked FDI as an important factor in accelerating economic success and wealth of a country as well as a door in creating jobs, facilitating economy, and creating more competitive environment and contributing productivity to the host country. In Bangladesh, FDI plays a significant role in GDP acceleration and economic growth (Mottaleb 2007). FDI has an unmentionable role in the modernization of the Bangladesh economy for last two decades. It helps the country in building up infrastructure, creating more employment, developing capacity, enhancing skills of the labor force of the host country through transferring technological knowledge and managerial capability, and helping in integrating domestic economy and the global economy. Various positive attributes of Bangladesh is now drawing the attention of the investors from both developed and developing countries. In Bangladesh, it iavailable to get skilled labor at relatively low wages. Moreover, there is reasonably stable macroeconomic environment. These two important factors can make Bangladesh an alluring destination for foreign investors. Lowest wage rates among the Asian countries, tolerable inflation rate, reasonably stable (except previous year) exchange rate, investment friendly custom regulations and attractive incentive packages make Bangladesh a favorable investment destination. Bangladesh became more open toward FDI policies over the last decades. These above features will certainly maintain the recent advancement in FDI investment in Bangladesh by the foreign investors. During 1980s, FDI to Bangladesh was very little and mostly focused in banking and a few other sectors. Bangladesh started attracting FDI since 1996 in energy and power sector because of favorable and supportive policies for foreign investment, economic reform as well as unexplored gas and oil resources. In 1972, annual FDI inflow was 0.09 million USD and in 1996, it became 231.61 million USD which rose significantly in 2008 to 1086 million USD which declined to 913.32 million USD in 2010 (source: Bangladesh Board of Investment).

Regional

After gaining political independence in the 1960s, African countries––like most developing nations––were very skeptical about the virtues of free trade and investment. Consequently, in the 1970s and 1980s several countries in the region imposed trade restrictions and capital controls as part of a policy of import-substitution industrialization aimed at protecting domestic industries and conserving scarce foreign exchange reserves. There is now substantial evidence that this inward-looking development strategy discouraged trade as well as foreign direct investment (FDI) and had deleterious effects on economic growth and living conditions in the region (Rodrik, 1998).

The disappointing economic performance of African countries beginning in the late 1970s up till the mid-1990s, coupled with the globalization of activities in the world economy, has led to a regime shift in favor of outward-looking development strategies. Since the mid-1990s, there has been a relative improvement in economic performance in a number of African countries as a result of the change in policy framework (Fischer, Hernandez-Cata, & Khan, 1998). Available data for sub-Saharan Africa indicate that the average annual growth rate of real GDP per capita which was −0.9% over the period 1975–1984 rose to 0.7% in the period 1995–2002 (Fig. 1). But the progress made so far is not enough for sustained growth and development in the region. Over the past three decades, Africa's participation in the world economy has declined. The region's share of world exports fell from 5.9% in 1980 to 2.3% in 2003. Its share of world imports declined from 4.6 to 2.2% over the same period (Table 1).

Improvements in economic policies are needed to enhance macroeconomic performance and attain the minimum growth rate required to meet the Millennium Development Goals set by the United Nations. An increase in investment is crucial to the attainment of sustained growth and development in the region. This requires the mobilization of both domestic and international financial resources. Given the unpredictability of aid flows, the low share of Africa in world trade, the high volatility of short-term capital flows, and the low savings rate of African countries (Fig. 2), the desired increase in investment has to be achieved through an increase in FDI flows, at least in the short-run.¹

Until recently, FDI was not fully embraced by African leaders as an essential feature of economic development, reflecting largely fears that it could lead to the loss of political sovereignty, push domestic firms into bankruptcy due to increased competition and, if entry is predominantly in the natural resource sector, accelerate the pace of environmental degradation. Moss et al. (2004) argue that much of African skepticism toward foreign investment is rooted in history, ideology, and the politics of the post-independence period. They also argue that the prevailing attitudes and concerns in the region are due in part to the fact that policymakers in the region are not convinced that the potential benefits of FDI could be fully realized in the region. Clearly, the sector in which a country receives FDI affects the extent to which it could realize its potential benefits. In East Asia, substantial FDI went into the secondary sector thereby contributing to the diversification of the export base and to higher and sustained growth. Africa, on the other hand, receives FDI mostly in the primary sector, and so the benefits to the region have not been as significant as in East Asia. In this regard, a key challenge facing Africa is how to attract more FDI in dynamic products and sectors with high income elasticities of demand.

Although most of the concerns of African countries regarding foreign investment are legitimate––for example, there is some evidence that the activities of foreign oil firms in Nigeria have had perverse effects on the local environment (EIA, 2003)––experience has shown that if a host country creates an environment conducive to investment, FDI can play an important role in its development efforts. Its potential benefits include:

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Employment generation and growth: By providing additional capital to a host country, FDI can create new employment opportunities resulting in higher growth. It can also increase employment indirectly through increased linkages with domestic firms. More specifically, the location of a foreign firm in a host country generally leads to the establishment of domestic firms that provide inputs to it thereby increasing the demand for labor in the economy. Aaron (1999) provides evidence on the positive impact of FDI on employment in developing countries.

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Supplementing domestic savings: African countries have low savings rates thereby making it difficult to finance investment projects needed for accelerated growth and development. Available data indicate that in sub-Saharan Africa gross domestic savings as a percentage of GDP fell from 21.3% over the period 1975–1984 to 17.4% in the period 1995–2002. Furthermore, the gap between domestic savings and investment was −1.9% of GDP over the period 1975–1984 and −1.0% of GDP during the period 1995–2002 (see Fig. 3). FDI can fill this resource gap between domestic savings and investment requirements.

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Integration into the global economy: Openness to FDI enhances international trade thereby contributing to the integration of the host country into the world economy (Morrisset, 2000).

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Raising skills of local manpower: Through training of workers and learning by doing, FDI raises the skills of local manpower thereby increasing their productivity level. The idea that FDI enhances the productivity of the labor force is supported by empirical evidence suggesting that workers in foreign-owned enterprises are more productive than those in domestic-owned enterprises (Harrison, 1996).

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Transfer of modern technologies: Foreign firms typically make significant investments in research and development. Consequently they tend to have superior technology relative to firms in developing countries. FDI gives developing countries cheap access to new technologies and skills thereby enhancing local technological capabilities and their ability to compete on world markets. Blomstrom and Kokko (1998) provide an interesting survey of the literature on FDI and transfer of technology.

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Enhanced efficiency: Opening up an economy to foreign firms increases the degree of competition in product markets thereby forcing domestic firms to allocate and use resources more efficiently.

There is a small literature dealing with issues related to FDI flows to Africa (see for example, Rogoff & Reinhart, 2003; Akinlo, 2003; Lemi & Asefa, 2003; Bende-Nabenfe, 2002, Asiedu, 2002a, Asiedu, 2002b; Schoeman, Robinson, & de-Wet, 2000). However, the existing literature focuses on the empirical determinants of FDI to the region, with very little discussion of concrete actions or strategies that could be adopted to promote FDI flows to the region. The present paper attempts to overcome this limitation. It emphasizes a new approach to the promotion of investment to the region that is based on improving relations with existing investors rather than focusing exclusively on costly activities of Investment Promotion Agencies. Furthermore, it identifies clearly what needs to be done at the national, regional, and international level to enhance FDI flows to Africa.

An identification of responsibilities and actions needed at the national, regional, and international level is important for two reasons. The first is that globalization has increased the competition for FDI flows among developing countries. Since Africa is not one of the preferred destinations for investment among foreign investors, it is increasingly being recognized that actions by African countries would have to be complemented by efforts at the regional and international levels in order to improve the prospects for FDI flows to the region (CCFA, 2003). Consequently, it is important to identify the responsibilities that are required at the various levels in order to reverse Africa's dismal FDI record. Second, the New Partnership for Africa's Development (NEPAD) and the G8 “Africa Action Plan” call for a new relationship between African countries and their development partners that is based on shared responsibility for development effectiveness and outcomes (G8, 2002, ECA, 2003, World Bank, 2003). One of the areas in which there is clearly a need for shared responsibility is the attraction of private capital flows to the region. It is therefore important to identify areas of responsibilities at different levels to give African policy makers and their development partners concrete ideas on what they can do to increase FDI flows to the region.

The structure of the rest of the paper is as follows. Section 2 presents a review of recent FDI trends while Section 3 deals with Africa's investment and trade relations with Asia. Section 4 analyzes Africa's FDI performance and potential and Section 5 provides explanations for Africa's poor FDI record. Section 6 outlines and examines measures to promote FDI flows to Africa, while Section 7 deals with prospects for FDI flows to the region. The last section contains some concluding remarks.

 

Recent trends in FDI

The rapid advances in technology in the last few decades––especially in transport and communication––have led to tremendous increases in FDI. Global inward FDI flows rose from US$ 59 billion in 1982 to a peak of US$ 1491 billion in 2000. On an annual average basis, FDI inflows increased from 23.1% in the period 1986–1990 to 40.2% over the period 1996–2000. Furthermore, FDI outflows rose from 25.7 to 35.7% within the same period (UNCTAD, 2003).

In 2001, FDI flows declined for the first time since

Asia, trade and FDI flows to Africa

In terms of sources of FDI flows to Africa, the United States, France, the United Kingdom, Germany, and Portugal accounted for most flows to the region from 1996 to 2000. Within the same period, the United States is the most important source of FDI flows into the region, accounting for approximately 37% of inflows from developed countries. This represents a marked-shift from the period 1991–1995 in which the United Kingdom and France were the most important sources of FDI flows to the region (

FDI performance and potential

Policymakers are often interested in the performance of their economy relative to its potential. Recently, UNCTAD computed two indices for assessing economies in terms of FDI inflows: the inward FDI performance and potential indices. The inward FDI performance index is computed as the ratio of a country's share in global FDI flows to its share in global GDP. For any given country, if the value of the index is one, this means that the country receives FDI consistent with its relative size. If

Explaining Africa's poor FDI record

Various explanations have been adduced for Africa's poor FDI record. In the empirical literature, the following factors are important determinants of FDI flows to the region.

Promotion of FDI to Africa

One of the development challenges facing African leaders today is how to attract FDI to the region. A number of efforts have been made in the past to boost FDI flows to the region but they have not had any significant impact. These efforts were unsuccessful because they were ill conceived, did not lift underlying constraints on FDI to the region, and failed to confront the challenges to the attraction of FDI to the region posed by the globalization process.

In designing policies and measures to

Prospects for FDI flows to Africa

Despite the dismal FDI record of African countries, there is room for optimism because recent developments in the region in the last few years signal a change in attitude towards more openness to FDI flows. More specifically, we believe that there will be modest improvements in FDI flows to the region in the medium to long-term because of the following:

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FDI policies in Africa are improving––profit repatriation is now permitted in most countries, tax incentives are commonplace, there is an

Concluding remarks

FDI can play an important role in the development efforts of the region. To date, African countries have not been successful in attracting significant FDI flows, reflecting largely the combined effects of political and macroeconomic instability, weak infrastructure, poor governance, inhospitable regulatory environments, intensification of competition for FDI flows due to globalization, and poor marketing strategies. There is the need to reverse the declining FDI trend in the region. This

Acknowledgements

We are grateful to participants at the Tokyo International Conference on Investment to Africa for useful discussions. We also thank two anonymous referees of the Journal of Asian Economics for very insightful comments. As usual, the authors are responsible for any errors and the views expressed in this paper do not necessarily represent those of the United Nations Economic Commission for Africa.