Determining FDI Potential: Are National Policies and Incentives Sufficient?

Foreign direct investment (FDI) is increasingly becoming a preferred form of capital flows to developing countries in recent years, as compared to other forms of capital flows. The reasons for this are not hard to seek. In the context of the gloom and despair of the heavy debt burden plaguing these countries, FDI promises to be the bright ray of hope for harnessing capital flows to the countrys economic development without the pangs of capital repayment with interest. In this context Feldstein and Razin (2000) and Sodka (forthcoming) note that the gains to host countries can take several other forms: FDI allows transfer of capital and technology, which is not possible through financial investment in goods and services. FDI also promotes competition in the domestic input market Profits generated by FDI contribute to the corporate revenue in the host country Operation of new ventures by FDI leads to employee learning in the host country who learn how to manage and operate the businesses. This contributes to human capital development of the host country. Profits generated by FDI contribute to tax revenues in the host country

FDI is different from other major types of external private capital flows in that it is motivated largely by the investors long-term prospects for making profits in production activities that they directly control. Foreign bank lending and portfolio investment, in contrast, are not invested in activities controlled by banks or portfolio investors, and are often motivated by short-term profit considerations that can be influenced by a variety of factorsfor example, interest ratesand are prone to sudden reversals (capital outflows) if any/some of these factors turn unfavourable. Mallampally and Sauvant (1999) claim that the importance of FDI also lies in the fact that it not only a means of transferring technology and skills and managerial practices, but also of accessing international marketing networks. The greater the supply and distribution links between foreign affiliates

and domestic firms, and the stronger the capabilities of domestic firms to learn from the presence and competition from foreign firms, the more likely it is that the qualities/attributes of FDI that enhance productivity and competition will spread. Recent evidence A comprehensive study by Bosworth and Collins (1999) on the effects of capital inflows on domestic investment for 58 developing countries during 1978-1995 covering nearly all of Asia and Latin America as well as most of Africa finds that an increase of one dollar in capital flows is associated with about 50 cents increase in domestic investment, while the ratio is about one-forone between FDI and domestic investment. There is virtually little or no impact or relationship between portfolio inflows and investment. FDI has also proved to be resilient during financial crises. Loungani and Razin (2001) point out that such investment was remarkably stable in East Asian countries during the global financial crises of 1997-98 in contrast to portfolio equity and debt flows, which were subject to large reversals during the same period. UNCTAD, in its recent World Investment Report, asserts that FDI has the potential to generate employment, raise productivity, transfer foreign skills and technology, enhance exports and contribute to the long-term economic development of the worlds developing countries. According to a recent UNCTAD report: on World Investment: Foreign affiliates of some 64,000 transnational corporations (TNCs) generate 53 million jobs. FDI is the largest source of external finance for developing countries. Developing countries inward stock of FDI in 2000 amounted to about one-third of their GDP , compared to just 10 percent 10 percent in 1980. One-third of global trade is intra-firm trade.

Similarly, Mallampally and Sauvant (1999) also assert that the increase in direct investment flows has laid the foundation for a marked expansion of international production by TNCs, which now have an estimated $3.4 trillion invested in about 449,000

foreign affiliates. The value of sales by these foreign affiliates has increased more rapidly than that of foreign trade (world exports). National Policies and Incentives for FDI in Bangaldesh The second half of the 1990s witnessed a surge of FDI inflows in Bangladesh, with the major sectors attracting FDI being oil, gas and power, followed by chemical industries and cotton and textile industries. USA, Malaysia and UK dominate the FDI scenario in Bangladesh. However, the inflow of FDI compared to neighbouring developing countries is below expectations. To understand why this is so, it is necessary to look into the national policies and incentives for FDI in Bangladesh. Like other developing countries, Bangladesh has also adopted a number of policies and provided generous incentives to attract foreign direct investment (FDI) into the country In According to experts, Bangladesh seems to offer perhaps the most liberal FDI regime in South Asia. These, among others, include: tax holiday for 5 to 7 years, income tax exemption for 15 years for the experts of foreign enterprises, protection from double taxation, exemption from duty for importing machinery and spare parts for 100 per cent export-oriented units, full repatriation of profit and dividend by the foreign companies, eligibility for full working capital loans from the local banks on banker-client relationship, option for foreign firms or joint ventures not to sell their shares through public issues, and protection from expropriation by the state under Foreign Investment Promotion and Protection Act of 1980. Bangladesh is also a signatory of the Multilateral Investment Guarantee Agency insuring investors against political risk. As a member of World Intellectual Property Organisation (WIPO) and World Association of Investment Promotion Agencies (WAIPA) the country further safeguards the interest of foreign investment. Standard dispute settlement procedures are followed in case there is any dispute with the government or with any private party. If the foreign investors feel that their rights have been violated, they can file writs with the High Courts. However, recent trends in global FDI flows lead one to conclude that national policy guidelines and incentives are not the main determinants of FDI. Despite the best tax reliefs and other incentives compared to neighbouring countries, a countries FDI potential may still be low, or it may be an under-performer. To understand these issues, let us look into

the economic determinants of FDI, the reasons for investment from the investors point of view, as well as what determines the FDI potential of a country. Economic Determinants of FDI From an economic perspective, determinants of FDI can be grouped into resource-oriented and market-oriented determinants. The resource-oriented determinants include availability of raw materials, low-cost skilled/unskilled labour, technology-created or innovationcreated assets and physical infrastructure. Market-oriented determinants for FDI inflows from the host countrys perspective generally refer to the market size and marketability of the field products for which FDI is sought. Projects that depend on a resource (e.g. oil and gas and mineral processing projects) often have to compete for capital funds with similar projects proposed elsewhere to investors. Proponents of non-resource-based projects seek the lowest cost/highest return location for their investments. Other economic factors such as liberal industrial policy reforms, liberalization of policies related to FDI, investment treaties with other countries for promotion and protection of investment, incentive packages, etc. come after consideration of the factors mentioned earlier. FDI Story From The Other Side: Why Foreign Firms Look Abroad [change and shorten] There are various theories explaining the behaviour of multinational corporations (MNCs) in investing abroad. A summary of some of those theories may be forwarded to explain the behaviour of MNCs. [shorten these theories] A transactional theory of MNE (Multinational Enterprises) has been forwarded by Caves (1981). According to him, MNEswhich are essentially multi-plant firmscan be grouped into three broad categories: 1. Horizontal multi-plant firms

2. Vertical multi-plant firms 3. Diversified MNEs Horizontal Integrationthe Intangible Asset Theory It has been empirically observed that plants in different countries under common control of an MNE tend to have greater profitability through lower costs than if they operate under different managements. An explanation for this behaviour is found in some peculiar characteristic which an MNE possessessome intangible assetunique to the firm. Such intangible asset may be in the form of a special skilltechnology, know-howor it may be in the form of a trade mark, or special skill in marketing a product. When an outside firm operates in a country, it is put up with costs not faced by the local firm, such as familiarity with the environment (including language, culture, etc.), sources of raw materials, the local firms way of doing things, etc. Therefore, the successful foreign firm must have certain transactional advantages which offset the costs and place it over local competitors. Vertical Integration An MNE can exist in vertical integration as well. Suppose a processing firm needs information about future prices and available raw materials for its production plans. The producers of that raw material may withhold that information. In such a case, the processing firm stands to gain by vertical integration. The presence of multinationals in the services sector such as banking or advertising is also explained by the transactional theory. Due to long-term relationship with its client or some other special facilities it provides, a bank may grow a special relationship with its customers in a country, which lowers the costs of transactions. It can use these techniques in other countries to derive similar advantages. Thus it goes multinational. Diversified MNE Multinational firms can be divided into a third categorythe diversified MNE. According to Caves, since foreign investment is a risky activity, an MNE could diversify its risks by investing across countries. Economic conditions are generally uncorrelated

across countries. Therefore, adverse economic conditions, governments policy changes, etc. could have a downward effect on investments in a country, but if investments were spread among countries, such losses could be wholly or partially offset by gains in another country. Diversification among products also tends to reduce risks in a similar manner. Investment in LDCs offers a strong case for an MNE to diversify its interest among different products in view of the restriction posed by many LDCs on repatriation of profits, royalties, etc. Once a company has decided to look abroad, the next step begins: investigation. The company sends a team to investigate the setting abroad. A partial listing from the Foreign Investments Checklist for US business abroad includes the following: FOREIGN INVESTMENT CHECKLIST: Some Factors For Consideration By US Business In Exploring Investment Abroad 1) The general political atmosphere 2) Attitude of the foreign government towards foreign investment 3) Administrative practices affecting the prospects in investment, such as import quotas, tariffs, availability of patent/trade-mark., etc. 4) Existence of investment guarantee agreement with US 5) Government assurances regarding remittance of profits and repatriation of capital 6) Tax rates which effect the proposed enterprise 7) Trade agreements with other countries 8) Availability of auxiliary industries 9) Extent and elements of competition 10) Extent of market 11) Availability of domestic raw materials and spare parts These are the issues on which a company tries to make information available. But a little reflection will reveal that to gather all the information is an extremely difficult time

consuming and costly affair. So it may not be practical. The company is thus faced with a limitation which forces it to adopt these methods. First, preliminary investigation starts at the companys office, on the basis of readily available information, and executives are directed to go into the country only if the company qualifies in the first three criteria tests. Second, the high cost of obtaining information poses a barrier to investment in the LDCs, so the willingness of a company to invest will be higher the more easily and readily information is available. Thirdly, since a lot of information will not be covered, the firm will stress on flexibility as a guard against uncertainty. Rigid terms offered by a host country will refrain the firm from investing there. At the end of investigation, it is logical to assume that the next step would be to take the decision whether or not to invest. But this is not always so. According to Aaron (__) decisions to invest are sometimes taken a priori, on the grounds such as commitment to hold the market or to protect the initial investment, and investigation seeks how to implement the decision. UNCTADS FDI Performance Index The United Nations Conference on Trade and Development (UNCTAD). conducted analysis to provide truer measures of the performance of the countries in attracting FDI. First, they created the FDI Performance Index by calculating the ratio between each countries' share in global FDI to its share of global GDP. Second, they constructed the FDI Potential Index, using a set of structural variables to assess the potential for countries to attract FDI. These two indices were then used to split countries into one of four categories:

front-runner - high FDI potential and performance, consisting of developed countries utilising their potential; above-potential - low FDI potential but high FDI performance; below-potential - high FDI potential but low FDI performance; and under-performer - low FDI potential and performance, consisting of developing countries limited by poverty or instability.

The second and third categories are most interesting, as countries in the first and fourth categories are performing to expectations. The second category is drawing more than their

potential warrants, while the latter group has shortcomings that are preventing their structural FDI from being realised.

Table 6 INWARD INVESTMENT PERFORMANCE AND POTENTIAL (1999 - 2001)

High FDI Low FDI Performance

Performance

High FDI Potential Front-runners Includes: Canada, Germany, United Kingdom, Malaysia, New Zealand Below-potential Includes: Australia, United States, China, Qatar, Japan, Low FDI Potential Above-potential Includes: Albania, Brazil, Honduras, Papua New Guinea, Vietnam Under-performers Includes: Bangladesh, India, Iran, Nepal, Sri Lanka, Turkey

Data source: UNCTAD

Regarding Bangladesh, the UNCTAD mentions that Bangladesh has reached the 122nd position from 133rd in the World Investment Report (WIR) index of the UNCTAD. According to the report, Foreign Direct Investment (FDI) rose by 72 per cent in 2004 over the previous years figure. Factors Determining The Inward FDI Potential Index The Inward FDI Potential Index captures several factors (apart from market size) expected to affect an economys attractiveness to foreign investors. It is an average of the values (normalized to yield a score between zero, for the lowest scoring country, to one, for the highest) of 12 variables (no weights are attached in the absence of a priori reasons to select particular weights): GDP per capita, an indicator of the sophistication and breadth of local demand (and of several other factors), with the expectation that higher income economies attract relatively more FDI geared to innovative and differentiated products and services. The rate of GDP growth over the previous 10 years, a proxy for expected economic growth. The share of exports in GDP, to capture openness and competitiveness.

As an indicator of modern information and communication infrastructure, the average number of telephone lines per 1,000 inhabitants and mobile telephones per 1,000 inhabitants. Commercial energy use per capita, for the availability of traditional infrastructure. The share of R&D spending in GDP, to capture local technological capabilities. The share of tertiary students in the population, indicating the availability of highlevel skills. Country risk, a composite indicator capturing some macroeconomic and other factors that affect the risk perception of investors. The variable is measured in such a way that high values indicate less risk. The world market share in exports of natural resources, to proxy for the availability of resources for extractive FDI. The world market share of imports of parts and components for automobiles and electronic products, to capture participation in the leading TNC integrated production systems (WIR02). The world market share of exports of services, to seize the importance of FDI in the services sector that accounts for some two thirds of world FDI. The share of world FDI inward stock, a broad indicator of the attractiveness and absorptive capacity for FDI, and the investment climate.

A formula for determining investment potential in Asia [Modify write-up language] A formula for determining investment potential in Asia is proposed by Lawrence Yeo, founder, CEO and principal consultant of AsiaBiz Strategy. He explains the best way for companies to gain market entry in Asia by using a formula that identifies opportunities, explores resources and analyses core competences before making a move. Many of our repeat Fortune 500 and global clients have regularly sought our Asia market entry and marketing strategy advice, because Asia is so heterogeneous and diverse. They ask: Is Asian Country 1s industry X attractive? How about Asian Country 2s industry Y? Such randomised market selection and industry targeting is inadvisable. To share with our corporate readers how we advise clients to enter Asia, here is a sneak peak inside the mind of an aspiring world-leading Asian consultancy. We can identify and assess Asian opportunities using a simple framework that can be easily yet simultaneously performed across many Asian countries at once. First, we review the clients Asia strategic intent and mission. Next we analyse the external environments of Asian countries (legal and regulatory environment, competitive

environment, business environment, and so on) and the internal environment of the client (key success factors, value/distribution analysis, marketing or branding audit, Asia strategy review, and so on). And finally we formulate the appropriate Asia strategy. Three-part formula The strategy formula has three parts: A, B and C:

A is identify and assess Asia opportunities; B is explore resources and capabilities to determine the best strategies; and C is analyse core competences to determine modes of entry into the Asian market. This is followed by strategy implementation.

To help assess the attractiveness of various Asian markets and industries, we further modify the GE-McKinsey Portfolio Analysis. Market attractiveness Market attractiveness has replaced market growth as the main factor of industry attractiveness. In turn, many factors can affect market attractiveness, such as market size, market share, market profitability, pricing trends, competitiveness intensity, entry barriers, market segmentation, and so on. Lets take Singapore for example. We can use a rating scale from 1 to 5 where 1 means very unattractive and 5 means very attractive. The model takes into account ratings for:

GDP output Market growth rate over the past five years: growth is the most important assessment factor and it takes precedence over size and other factors when considering industry attractiveness. It is based on the historic growth of each industry for the past five years. Concentration of companies within the same industry: high competitive intensity translates to lesser profit shared among players, hence lowering attractiveness of the industry. Product sales nature: this is defined as the dependency of sales of products/services in the specific industry on the changes in the business environment.

10

Government support: the Singapore government plays an active role in supporting Singapores business; therefore government support is a crucial factor for evaluating industry attractiveness.

Here, our analysis shows that Singapores industries, in order of descending attraction, are:

High attractiveness: wholesale and retail; transport, logistics and communication; business/ commercial/professional; IT and e-commerce; and other services. Mid attractiveness: food, beverages and tobacco; electronic products and components; other manufacturing sectors and financial services. Low attractiveness: wearing apparel; footwear and leather; publishing and printing; construction and engineering; and hotels and restaurants.

Market conditions Also, we look at our clients market strength. For small and medium-sized enterprise clients, we will look at Asian market conditions and likely Asian competitors countermoves and recommend using a niching strategy, substitution strategy, free-riding strategy and strategic alliance strategy or some combination of these. The Asian Development Bank also points out that foreign firms are attracted to commercially profitable and politically stable environments, and that offering incentives is often less effective at attracting investment. A recent issue of The Asian Development Outlook, states that FDI in developing Asia grew from $694 million in 1970 to $ 138.6 billion in 2000, before declining to $ 90.1 billion in 2002, representing a growth of 15.2 percent per year. In order to attract the huge amount of foreign direct investment pouring into the region, economies should move away from restrictive investment regimes and alow wholly owned subsidiaries to operate.

FDI situation Bangladesh According to an UNCTAD report, FDI to Bangladesh averaged $7 million annually from 1990-1996, but increased to an annual average of $196.8 million from 1997-2000, primarily due to foreign investment in Bangladeshs energy sector. In 2001, however, new FDI dropped 72% (to $78 million) from the previous year. In 2002 new FDI again dropped to $52 milli0on. But in 2003 the FDI jumped to $120 million.

11

Bangladesh has, very often sent trsde delegations abroad to explore trsde opportunities as wel as highlightopportunities for investing in Bangladesh. A number of foreign business delegations have visited Bangladesh to explore trade and investment opportunities, including from India, France, Turkey, Malaysia, Taiwan China, and Korea. What is the story from the other side? How do foreigners see inveetment prospects I Bandladesh? A survey of recent reports on the issue including a recent Investment Climate Statement on Bangaldesh by the Bureau of Economic and Business Affairs of the US Government found the following: foreigners often find that ministries request unnecessary licenses and permissions. Added to these difficulties are such problems as corruption, labour militancy, poor infrastructure, inadequate commercial laws and courts, inconsistent respect for contract sanctity, and policy instabilityfor exampledecisions taken by previous governments being overturned when a new government comes to power). To a lesser extent, difficulty in attracting foreign investment also results from Bangladesh's image as an impoverished and undeveloped country subject to frequent and devastating natural disasters. Imperatives for Bangladesh Despite the overall poor investment environment, Bangladesh achieved notable success in some fields during the past years. By the end of the last decade, growth rate of GDP exceeded 5 percent, whereas population growth rate declined to 1.5 percent. Hence per capita income was increasing at a rate of more than 3 percent a year. The situation is much better than what it had been in the 1980s when GDP growth rate hardly exceeded the population growth rate. Investment has increased to 22-23 percent of GDP. Private investment marked a faster growth than public investment. Dependence on foreign aid declined significantly. Sectoral composition of the economy also marked some positive changes. Share of agriculture now declined to around 25 percent, while share of service and industry has increased to 50 percent and 25 percent respectively. Inflation rate is very low. Overall macroeconomic balance had been sustainable in the last decade, until the FY2002. 3.2. Success of Bangladesh is quite remarkable in select social and economic sectors. Bangladeshs literacy rate has increased to more than 60 percent during the past decade. Textile and some other manufacturing sectors registered modest success. Some of Bangladeshs textile sector units are using state of the art technology and are capable of competing in the global market. Likewise, pharmaceuticals and cement industries have experienced significant quality and capacity expansion. The countrys industrial and To be competitive in international markets, and to upgrade its potential in the foreign investors eyes, Bangladesh needs to adopt urgent plans for the short-run and the medium term. Here a distinction has to be made regarding factors and situations which are outside the direct control of the government and those over which it can exercise direct control and

12

initiative. While indices such as increase in the GDP per capita, share of exports in GDP and increasing the share of FDI in the services sector are not under direct control of the government, and can only be influenced indirectly by it, the government should take immediate initiatives to develop those sectors directly under its control. such as developing the infrastructure, specifically port infrastructure and ICT Developing infrastructure Developing the infrastructure particularly Chittagong port is an utmost priority for developing FDI potential in Bangladesh. {Mention example of SINGAPORE] Chittagong port is commercially important to Bangladesh as it handles nearly 85 percent of the countrys exports and imports. Besides, Bangladesh is located at the centre of the South Asia Regional Economic Co-operation (SASEC) countries, having borders with India and Mynmar and with close proximity with land-locked countriesNepal and Bhutan. However, problems like outdated machinery, inadequate storage space, time-consuming custom procedures, and hartals make it one of the costliest ports in Asia. The port is heavily congested and ship turnaround time needs 4 to 5 days compared to 1 to 2 days in Singapore and Bangkok. Besides, the number of export containers has not increased at a pace matching the rate of increase in the number of feeder vessels. Container handling costs around $600 as against $150 to $300 in neighbouring ports.It may be mentioned here that as a measure to make the port more efficient, the Government initiated measures such as import of gantry cranes. Four gantry cranes were commissioned at the port on January 30, 2006 to make cargo handling more efficient. But due to inefficient management, notably, absence of skilled operators and modern vessels, they are being used up to only a third of their capacity According to port officials, although each of the cranes has a capacity of handling 30 TEUs (Twenty Equivalent Units) of containers per hour, they can hardly handle more than 10 TEUs per hour. Port users have recommended privatization as well as corporatization of maritime ports of Bangladesh, including Chittagong Port, to bring them in the capital market and thus make them efficient for handling growing volumes of cargo. In keeping with thesituation, the Bangladesh Government has decided to allow private sector participation in the port sector. Additionally, for expediting port services, the Government may opt for leasing of equipment for port handling and leasing of floating crafts from the private sector. Similarly, Bangladesh Railway too is incapable of carrying and delivering the container cargoes efficiently and timely due to poor capacity, and lack of operational efficiency. Despite huge demand, Bangladesh Railway currently accounts for less than 15 percent of container trans-shipment in the Dhaka-Chittagong Economic Corridor (DCEC), which provides potential sub-regional linkages to northeastern states of India as well as Nepal and Bhutan. Regarding road infrastructure, although there has been a rapid expansion of road network, there is hardly any significant trans-shipment through road transport because it cannot handle container lorries due to capacity constraint. So far as Information and Communication Technology (ICT) is concerned, the country is at an emerging stage and lacks behind other Asian countries in comparison. However, a mentionable initiave is that the Ministry of Science and Information &

13

Communication Technology, in cooperation with the public/private sector, has taken program to produce quality professionals and skilled manpower in ICT. National ICT Task Force decided to introduce ICT Internship Award Programme in the country. Under this program, graduates/ fresh graduates/post graduates in ICT subjects will be imparted training for 6-months as internees in different IT organizations/companies for acquiring practical experience and hands on training. The objective of the program is to impart basic training for skill development. Conclusion From the above it may be concluded that to attract FDI in a meaningfully large way , it is important for Bangladesh to look beyond offering lucrative incentive packages and also inculcate the criterion leading to increasing its FDI potential within a short time.

14