Friday, July 13, 2012

Promoting investment (not just FDI)

Investment promotion is often seen purely as encouraging foreigners to invest in a country, especially in the form of foreign direct investment (FDI).

This may be necessary if a country is so poor that it has no domestic investors. But this is rarely the case. Many poor countries have unequal distributions of income and wealth so that although their GDP per capita is low there are some very rich individuals and families with fortunes that could be invested in their country. It's no surprise that those fortunes are often invested outside the country. This isn't just a case of ill-gotten gains from corruption being hidden in Swiss bank accounts to provide income in case a crooked politician has to flee a coup or a rebellion, though this is probably more common than it ought to be. There are also people with legitimate savings who see no future investing in a country where the returns are low, high-risk, or both. The result is capital flight.

Investment promotion ought to address capital flight as much as it seeks to attract FDI.

Domestic investment has inherent advantages. Inhabitants of a country know the local conditions, including the language, culture, customs, consumer tastes, available skills and many other things that foreign investors need time (or a local partner) to acquire.

Look at it another way: if the business environment is so unattractive that even people who live in a country refuse to invest in it, how can you attract people outside the country to do so?

The answer often is positive discrimination, in the form of fiscal incentives such as tax breaks for foreign investments. This is sometimes rationalized thus: our country is too poor and its institutions too undeveloped to be able to provide a business environment that is satisfactory for foreign investors, so we will reward them with subsidies/incentives until things improve.

Reasonable? Sit back and think about it. A country where living standards are low is using or forgoing tax revenue that could otherwise be used to build infrastructure to reward (effectively bribe) a multinational corporation from a rich country to invest there. Doesn't that sound silly? And what about the domestic investors who don't qualify for the tax breaks? Isn't this also an incentive for them to invest elsewhere?

"Not if it works," I hear you say. Perhaps so. But let's imagine that all neighboring countries offer the same or more generous incentives to divert FDI to themselves. In that case, the country that first offered the incentives is no better off in terms of FDI attraction. Fiscally, it is definitely worse off, as it is not getting the taxes from profitable foreign investments that it would get from domestic investments. In practice, this is what happens, as you can see by visiting the websites of developing-country investment promotion agencies, which often consist largely of lists of juicy incentives.

So what would attract foreign investors? Surveys of multinational corporations show that fiscal incentives are low on the list of priorities when selecting a country to invest in. Naturally, no company is going to say that to an investment promotion agency with whom they are trying to cut a deal. But there are many other things that they look for first, such as the rule of law and predictability of the institutional framework.

Am I, then, suggesting that all countries ditch their fiscal incentives for FDI? Well, yes, but not necessarily immediately. The "cold turkey" solution may be too brutal. Instead, countries that have relied excessively on such incentives can benefit from removing them gradually as they focus more sharply on improving more important elements of the business environment. This gradualist approach will also be easier to "sell" to foreign multinationals and their shareholders. Foreign chambers of commerce may object, but not for long once they see real improvements in things like customs clearance which directly affect their members' business operations.

Investment promotion agencies that have concentrated on luring foreign investors with fiscal incentives can actually become more powerful and effective by developing a new role for themselves. As the first stop for foreign companies considering an investment, the investment promotion agencies can put together information to help those companies find what they want. At least as important is their function as a channel for information back to governments on problems faced by foreign investors. If they wish to systematize and analyze this information, they may even be in a good position to recommend improvements to the investment environment in a practical, pragmatic way that can be relatively easy to implement. In this way, investment promotion agencies can transform themselves into an essential component of the investment policy making machinery.

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