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Foreign investment – how good is it for development?

Added 22/Aug/12

By Jesse Griffiths,

Summer’s a great time to catch up on reading – and where better to start than UNCTAD’s World Investment Report 2012, published in July. Two really interesting parts caught my eye – the “Foreign Direct Investment (FDI) contribution index”, and the new “investment policy framework for sustainable development” – more about them after a quick run-through of some of the headline figures.

FDI continues to rise, though it’s still a way off its 2007 peak, and the majority continues to be in developing countries and emerging markets. The 2011 figure - $1.524 trillion – sounds impressive, but is tiny when compared with domestic investment in most countries, and small compared with world trade. The value of FDI is not so much about numbers, but about other ways it can contribute to economic development and poverty reduction.

FDI’s contribution to development
So it’s worth looking in more detail at UNCTAD’s “FDI contribution index”, which “ranks economies … in terms of value added, employment, wages, tax receipts, exports, R&D expenditures and capital formation.” UNCTAD recognises the limitations of this approach – it doesn’t capture all “impacts across the spectrum of labour, social, environmental and development issues” for example, but I think it does produce a number of interesting insights.

The most striking thing is how variable countries are at capturing the benefits of FDI. Some differences are structural – for example, “the higher ratio for employment compared to value added for developing countries reflects the fact that the labour-intensity of production there is higher than in developed countries.” But a lot of them are about policies.

Campaigners for tax justice will note that:

“a group of economies with a significant presence of …[Trans-national corporations] … receives a below-average contribution of FDI in terms of the Index indicators. This group includes a number of economies that attract investment largely owing to their fiscal or corporate governance regimes (including tax havens and countries that allow special-purpose vehicles or other corporate governance structures favoured by investors. such as Luxembourg and the Netherlands). Such regimes obviously lead to investment that has little impact in terms of local value added or employment. [the emphasis is mine.]

This confirms the view that offering tax breaks to attract inward investment is a policy tool that has been over-promoted, without real evidence that it has a strong pay-off in development terms. Also, as others have pointed out, the favourable treatment of foreign investors creates a loop-hole which is often exploited by domestic investors who route their investments via offshore structures with concealed ownership. For example Mauritius is the biggest source of FDI into India much of this is believed to be from wealthy Indians posing as foreigners to get tax breaks and other goodies. This is known as round tripping, which inflates FDI figures and saps domestic government revenue.

UNCTAD also argues that active government investment policies play an important role:

“A number of major emerging markets – Argentina, Brazil, China, Indonesia and South Africa – appear to get a higher contribution to their economies ‘per unit of FDI’ than average, with high quartile rankings in exports, employment, wages and R&D… In some cases this may be due to active investment policymaking; for example, channeling investment to specific higher-impact industries.”

What’s the best way to manage FDI?
So UNCTAD’s creation of a new “Investment policy framework for sustainable development” seems to me to be a very useful step. It’s intended to “serve as a point of reference for policymakers in formulating national investment policies and in negotiating or reviewing international investment agreements, with a particular focus on development-friendly options.” I haven’t examined it in detail, and I’m sure there are flaws (there seems to be very little recognition of the imbalances of power that frame investment treaties at international level, for example), but I’m not the only one to note that the core principles seem well framed, and should be at the front of everyone’s mind next time they’re confronted by the vacuous argument that attracting FDI is self-evidently always a good idea (it feels like I come across it daily, mostly from donor agencies…).

Here’s their list of core principles in full: