Asian Development BankP.O. Box 7890980 ManilaPhilippines

2003 by Asian Development BankDecember 2003ISSN 1655-5260

The views expressed in this paper are those of the author(s) and do notnecessarily reflect the views or policies of the Asian Development Bank.

The ERD Policy Brief Series is based on papers or notes preparedby ADB staff and their resource persons. The series is designed toprovide concise nontechnical accounts of policy issues of topicalinterest to ADB management, Board of Directors, and staff. Thoughprepared primarily for internal readership within the ADB, the seriesmay be accessed by interested external readers.

ERD POLICY BRIEF NO. 23

Foreign Direct Investment:The Role of Policy

Douglas H. BrooksLea R. Sumulong

December 2003

Douglas Brooks is Principal Economist, and Lea Sumulong isEconomics Officer, in the Macroeconomics and Finance ResearchDivision of the Economics and Research Department, AsianDevelopment Bank. The authors acknowledge Ifzal Ali, J. P. Verbiest,and Ernesto Pernia for helpful insights.

1 For more information, see Brooks et al. (2003).

This brief analyzes the policy context in which foreign directinvestment (FDI) flows occur.1 It highlights the value for ADB’sdeveloping member countries (DMCs) of incorporating theirinvestment policies in a development perspective, and learning fromthe experiences of countries that have successfully benefited from FDI.A favorable policy framework for FDI is one that generally provideseconomic and political stability, transparent rules on entry andoperations, equitable standards of treatment between foreign anddomestic firms, and secures the proper functioning and structure ofmarkets. In general, empirical evidence suggests that policiesencouraging domestic investment help to attract foreign investment.However, the importance of policy does not end there.

FDI contributes to the development process by providingcapital, foreign exchange, technology (including managerial andmarketing skills), competition, and export market access. It can alsostimulate domestic investment and innovation. While growinginternational reserves in many DMCs may have diminished the roleof policies meant to attract FDI as a source of financing investmentor foreign exchange, a more important role for policy is to ensure thathost economies maximize the overall net benefits from the FDI thatis received.

The Domestic Policy Context

In general, attracting internationally mobile factors of productionrequires host economies to improve the quality of their immobileassets, i.e., institutions (including those that enhance humanresources) and infrastructure (social, legal, and physical).Governments typically can improve FDI prospects by reducinguncertainty, asymmetric information, and related search and othertransaction costs (especially time and number of steps involved in

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acquiring approval) faced by foreign investors. Ultimately, however, theways in which FDI benefits or harms a host economy depends on thecontext in which the investment and resulting economic activityoccurs.

One area of great interest to host countries is technologytransfer. Investors put in more proprietary technology and procedureswhen they feel they have greater control over protection of theproprietary content transferred and greater freedom in its use.Restrictions such as forced sharing of technology through mandatoryjoint ventures, local content, or performance criteria reduce incentivesfor the investor to apply modern techniques and technologies,hindering integration into global sourcing networks.2 Subsidiariesreceive greater resources from parent firms than partially owned orindependent firms with lower transaction costs involved in technologytransfer. Thus, multinational investment is generally superior to directlicensing of technology. Technology transfer and interchange ofmanagers and technicians between parent and subsidiary firms havealso been found to be significantly higher for wholly owned subsidiariesthan for joint venture partnerships or licensees (Ramachandran 1993).

National-level programs promoting development of linkagesbetween foreign-invested firms and domestic firms commonly include:provision of market and business information; matchmaking by suchmeans as trade fairs or databases; and support to local enterprisesthrough provision of managerial and technical assistance, training,audits and, occasionally, financial assistance or incentives (UNCTAD2001, 183). The Economic Development Board of Singapore hassuccessfully encouraged foreign investors to voluntarily identifypromising local suppliers and contribute to vendor development.

With strengthened interest in human resource development andskill formation in FDI policy, many countries regulate the hiring offoreign workers and impose training requirements on foreign investors.Other countries, like Malaysia, chose to create infrastructure topromote linkages with foreign enterprises. Skills development centerswere set up to promote technical and vocational training and theSmall and Medium Industries Corporation was established to provideadvice, guidance, and assistance to enhance the competitiveness ofsmall and medium-size enterprises (Tham 2003). Such efforts mayhelp to reverse the decline in FDI flows to Southeast Asia.

2 Voluntary joint ventures spread risk and increase market access offering lessdisincentives for technology transfer, at least for more established technologies.

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Foreign direct investment has seen a dramatic rise in the last20 years due to increasing recognition of its benefits and growingopenness of host economies. Drying-up of commercial bank lendingdue to debt crises also brought some developing countries to reforminvestment policies to accept or attract foreign investment,encouraging both portfolio investment and the less volatile FDI.Incentives and subsidies are aggressively offered, particularly toforeign-source investments that support host countries’ industrialpolicies.

Most countries offer incentives—tax concessions, tax holidays,tax credits, accelerated depreciation, export subsidies, importentitlements, and subsidized utility rates—to attract FDI. The People’sRepublic of China, for instance, offers income tax exemptions toforeign enterprises on the first and second years, and 50 percentincome tax reduction from the third to fifth years. In addition, reducedincome tax rates are levied on foreign investment enterprises inspecial economic zones and open coastal regions—15 and 24percent, respectively, instead of the usual 30 percent (Wang 2003).Meanwhile, Thailand allows duty exemptions on imported rawmaterials and capital goods for FDI projects locating in exportprocessing zones (Tangkitvanich et al. 2003). Viet Nam also providesduty exemptions on imported capital goods and lower water andelectricity rates for firms locating in export processing zones (DPI2003). Such incentives aim to invite FDI and channel foreign firms todesired locations, sectors, and activities.

Many countries also regulate and limit activities of foreign firmsoperating within their borders. Such regulations often cover foreignequity ownership, local content requirements, local employment, andminimum export requirements. The Republic of Korea, for instance,used to limit foreign equity participation at 50 percent for every industrywithout exception (Lee et al. 2003). India, meanwhile, used to imposelocal content requirements to foreign investors in its automobileindustry to promote vertical interfirm linkages (Kumar 2003). This“carrot and stick” approach has long been a feature of the policyframework governing FDI in host economies (McCulloch 1991).

However, tax breaks and subsidies generally influence investmentlocation decisions only at the margin and run the risk of fostering a“race to the bottom” among competing potential locations. Mostpotential investors give more weight to the size and expected growthof the market to be served, long-term macroeconomic and politicalstability, skilled or trainable workers, and transportation andcommunications infrastructure. Financial incentives also often create

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distortions and inefficiencies. By distorting relative costs for othersectors and investment projects not targeted for incentives, suchschemes typically discriminate against smaller and domesticinvestors, as well as areas of comparative advantage not recognizedas such by policymakers. Perhaps of greatest concern, over timethese actions contribute to development of a governance system thatlacks transparency and accountability (JBICI 2002).

Too often, policies ostensibly designed to maximize net benefitsof FDI for recipient economies ignore their effects on incentives forinvestors and result in subscale manufacturing plants, frequentlythrough mandated joint ventures, which are not allowed to sourceinputs freely and contribute little to the country’s development.Arrangements between foreign investors and host economyauthorities blocking other new entrants to the industry or inhibitingalternative sources of supply are also common but generally not inthe best interests of the host economy. However, a host economy cancapture scale economy rents through licensing fees or increasedfactor prices as foreign firms bid up factor costs.

Incentives for a foreign investor and benefits for the hosteconomy will be less when the investment is directed toward servingsmall and protected domestic markets.3 The benefits to the hosteconomy are greatest when international companies exploiteconomies of scale both locally and globally, and update theirtechnologies and managerial practices to remain competitive.

The International Policy Context

In general, FDI is not influenced solely by domestic policies, butalso by international agreements. Foreign investors desiring toprotect their investments and receive favorable tax treatment on theirglobal profits and host countries wishing to attract greater inflows ofFDI have entered into thousands of bilateral and, increasingly, regionalagreements related to FDI. Most economies are now party to at leastone international investment agreement.

In bilateral and multilateral trade and investment negotiations,most favored nation (MFN) treatment obliges a host economy to offerequally advantageous investment conditions to potential investors

3 Efforts to protect domestic markets create incentives for foreign investors to reapsecondary oligopoly rents from older technology.

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from all treaty signatories. National treatment (nondiscrimination)requires similar treatment of both foreign and domestic investors.

Bilateral agreements also shape FDI policy frameworks. Over2,100 bilateral investment treaties (BITs) and 2,200 double taxationtreaties (DTTs) were in effect by end-2002 (UNCTAD 2003). These BITsgenerally contain binding commitments on expropriation, fundtransfers, and compensation due to armed conflict or politicalinstability, on a national treatment or MFN basis. DTTs, on the otherhand, usually identify measures to avoid double taxation of theinvestor by the host and home economies. Disagreements betweenforeign investors and host governments are usually referred to privatearbitration of the International Chamber of Commerce or theInternational Centre for Settlement of Investment Disputes.4

In BITs, commitments vary from one investment partner toanother. BITs are popular because they provide host economiesflexibility to screen and channel foreign investment to desired sectorsor locations while extending protection to foreign investors. Investmentprovisions in regional agreements are also common when a smallgroup of like-minded governments is more likely to reach agreementthan a larger number of governments with diverse opinions.

In the multilateral context, the WTO has established rulesassociated with trade-related investment measures (TRIMs). TRIMsare a subset of the incentives and regulations designed to influenceFDI, but are limited to those that have a direct impact on internationaltrade. Common TRIMs are local content requirements, exportperformance requirements, and trade balancing measures. Anothermeasure is denying foreign corporations access to host economymarkets. In the Doha round of WTO negotiations, investment is oneof what have been termed the “Singapore issues.”

Nevertheless, some governments remain cautious aboutcommitting to international investment rules. They see internationalrules as clamping down on their policy sovereignty and limiting theirability to reverse policy decisions; but these same rules encourageFDI. Host governments must thus find the right balance betweenretaining policy space and reaping the benefits from internationalcooperation (UNCTAD 2003).

4 While private sector arbitration mechanisms generally work satisfactorily, theyraise the potential for political disagreements in that a sovereign judicial system canbe overruled by an unelected and opaque arbitration panel.

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Conclusion

Evidence shows that host economy policies that maximizebenefits from FDI must include policies for macroeconomic stability,infrastructure reliability, and labor force training and development.Foreign firms are also more likely to adopt best practices when theycater to competitive host markets. Constraining them to serveprotected domestic markets gives them license to be inefficient, whilerewarding them with monopoly rents and reducing host economywelfare.

FDI facilitates integration into international supply chains,allowing host economies to increase efficiency of existing activitiesand to enter new economic activities. Allowing wholly owned affiliatesof foreign firms freedom to source from wherever they consideradvantageous is more likely to lead to domestic suppliers achievingeconomies of scale and becoming integrated into global supplychains. Externalities in adoption of production, quality control, andmanagerial processes (including export strategies) frequently spreadvertically within an invested sector and eventually to other sectors inthe host economy (Moran 2002).

Host economies should therefore not rely only on regulatory andincentive measures to attract FDI. Performance requirements such asjoint ventures, technology transfer, local content, and trade balancingrequirements may appear beneficial in the short run, but aredetrimental to development in the long run. Import-substitutingindustries benefiting from infant industry protection often do not growto become globally competitive; domestic content and joint venturerequirements for foreign investors often do not yield efficient stimulationof domestic supply chains. Host economies may forego revenues bygranting tax incentives such as tax deductions and exemptions, butnot receive the corresponding benefits. Host economies are usuallybest off ensuring that the local environment is conducive both todomestic and foreign investment.

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References

Brooks, D. H., E.X. Fan, and L. R. Sumulong, 2003. Foreign DirectInvestment in Developing Asia: Trends, Effects and Likely Issuesfor the Forthcoming WTO Negotiations, ERD Working Paper No.38. Economics and Research Department, Asian DevelopmentBank.

Department of Planning and Investment, 2003. “Mechanism, PoliciesEncouraging and Supporting Investment into ExportsProcessing Zones and Industrial Zones.” Available: http://www.dpi.hochiminhcity.gov.vn.

Japan Bank for International Cooperation Institute (JBICI), 2002.Foreign Direct Investment and Development: Where Do WeStand? JBICI Research Paper No. 15, Tokyo.

Kumar, N., 2003. “Foreign Direct Investment, Development and WTO:The Case of India.” Paper prepared for ADB RETA 5994: A Studyof Regional Integration and Trade—Emerging Policy Issues forSelected Developing Member Countries. Asian DevelopmentBank, Manila.

Lee, S. B., J. D. Kim, and N. G. Choi, 2003. “Country Paper: Korea.”Paper prepared for ADB RETA 5994: A Study of RegionalIntegration and Trade—Emerging Policy Issues for SelectedDeveloping Member Countries. Asian Development Bank,Manila.

McCulloch, R., 1991. Investment Policies in the GATT. NBER WorkingPaper Series No. 3672, National Bureau of Economic Research,Massachusetts.

Moran, T. H., 2002. Strategy and Tactics for the Doha Round:Capturing the Benefits of Foreign Direct Investment. AsianDevelopment Bank, Manila.

Ramachandran, V., 1993. “Technology Transfer, Firm Ownership, andInvestment in Human Capital.” Review of Economics andStatistics 75(4):664-70.

Tangkitvanich, S., D. Nikomborirak, and B. Krairiksh, 2003. “Thailand’sCountry Report on FDI.” Paper prepared for ADB RETA 5994: AStudy of Regional Integration and Trade—Emerging PolicyIssues for Selected Developing Member Countries. AsianDevelopment Bank, Manila.

Tham, S. Y., 2003. “Foreign Direct Investment in Malaysia.” Paperprepared for RETA 5994: A Study of Regional Integration andTrade–Emerging Policy Issues for Selected Developing MemberCountries. Asian Development Bank, Manila.

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United Nations Conference on Trade and Development (UNCTAD),2001. World Investment Report 2001—Promoting Linkages.United Nations, New York.

———, 2003. World Investment Report 2003—FDI Policies forDevelopment: National and International Perspectives. UnitedNations, New York.

Wang, X., 2003. “Foreign Direct Investment in China.” Paper preparedfor ADB RETA 5994: A Study of Regional Integration and Trade—Emerging Policy Issues for Selected Developing MemberCountries. Asian Development Bank, Manila.

ERD POLICY BRIEF SERIES

No. 1 Is Growth Good Enough for the Poor?Ernesto M. PerniaOctober 2001

2 India’s Economic ReformsWhat Has Been Accomplished?What Remains to Be Done?Arvind PanagariyaNovember 2001

3 Unequal Benefits of Growth in Viet NamIndu Bhushan, Erik Bloom, and Nguyen Minh ThangJanuary 2002

4 Is Volatility Built into Today’s World Economy?J. Malcolm Dowling and J.P. VerbiestFebruary 2002

5 What Else Besides Growth Matters to PovertyReduction? PhilippinesArsenio M. Balisacan and Ernesto M. PerniaFebruary 2002

6 Achieving the Twin Objectives of Efficiency and Equity:Contracting Health Services in CambodiaIndu Bhushan, Sheryl Keller, and Brad SchwartzMarch 2002

7 Causes of the 1997 Asian Financial Crisis:What Can an Early Warning System Model Tell Us?Juzhong Zhuang and Malcolm DowlingJune 2002

8 The Role of Preferential Trading Arrangementsin AsiaChristopher Edmonds and Jean-Pierre VerbiestJuly 2002

9 The Doha Round: A Development PerspectiveJean-Pierre Verbiest, Jeffrey Liang, and Lea SumulongJuly 2002

10 Is Economic Openness Good for RegionalDevelopment and Poverty Reduction?The PhilippinesErnesto M. Pernia and Pilipinas F. QuisingOctober 2002

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11 Implications of US Dollar Depreciation for AsianDeveloping CountriesEmma Xiaoqin FanNovember 2002

12 Dangers of DeflationDouglas H. Brooks and Pilipinas F. QuisingDecember 2002

13 Infrastructure and Poverty Reduction—What is the Connection?Ifzal Ali and Ernesto PerniaJanuary 2003

14 Infrastructure and Poverty Reduction—Making Markets Work for the PoorXianbin YaoMay 2003

15 SARS: Economic Impacts and ImplicationsEmma Xiaoqin FanMay 2003

16 Emerging Tax Issues: Implications of Globalizationand TechnologyKanokpan Lao-ArayaMay 2003

17 Pro-Poor Growth—What is It and How is It Important?Ernesto M. PerniaJune 2003

18 Public–Private Partnership for CompetitivenessJesus FelipeJune 2003

19 Reviving Asian Economic Growth RequiresFurther ReformsIfzal AliJune 2003

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For information and to order, write toOffice of External Relations, Asian Development Bank

P.O. Box 789, 0980 Manila, Philippinesor e-mail adbpub@adb.org

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20 The Millennium Development Goals and Poverty:Are We Counting the World’s Poor Right?M. G. QuibriaJuly 2003

21 Trade and Poverty: What are the Connections?Douglas H. BrooksJuly 2003

22 Adapting Education to the Global EconomyOlivier DupriezSeptember 2003

23 Foreign Direct Investment: The Role of PolicyDouglas H. Brooks and Lea R. SumulongDecember 2003