Friday, August 10, 2012

Investment promotion is more effective for developing countries

According to Torfinn Harding and Beata Smarzynska Javorcik of the University of Oxford, investment promotion agencies (IPAs) are highly effective in attracting investment to less-developed countries and far less so in promoting investment between developed countries. A small amount spent on promoting investment in such countries brings in a huge return both in FDI inflows and in job creation.

In their December 2011 paper "Roll out the Red Carpet and They Will Come: Investment Promotion, Information Asymmetries and FDI" in the Economic Journal, they provide a detailed analysis of the effects of IPAs in 124 countries, using newly-collected data, in an attempt to determine what aspiring FDI destinations can do to reduce barriers to investment flows across international borders.

Their findings suggest that investment promotion can be a potent tool for emerging markets wishing to attract FDI by decreasing information asymmetries, leading to higher FDI flows to developing countries. No such link was found for industrialized countries, where information on investment opportunities and the investment environment in general is much more readily available.

Investment promotion by developing countries also clearly offers plenty of bang for the buck. Harding and Javorcik found that US$1 spent on investment promotion leads to US$189 dollars of FDI inflows (so half a cent spent in investment promotion brings in a dollar of FDI). Put another way, it costs only US$78 in investment promotion spending to create one job.

These figures are based on calculations involving FDI from the USA, though it is likely that a similar result would apply for investment from other developed economies because the same factors apply. The figures also reflect average, not marginal, IPA spending, so they capture the benefits of an initial investment promotion effort rather than the returns to additional spending. Even with these provisos, this represents a massive potential gain to the host economy.

In discussions with governments of less-developed countries, I have frequently come across the concern that conditions are less than optimal for attracting FDI and it is difficult for the government to remedy the multiple problems involved in a short time, even though FDI is regarded as essential in stimulating economic development.

If you are in this position, don't worry, Harding and Javorcik's paper demonstrates that well-targeted investment promotion can help even if your economy is beset by obstacles. This is what it says (emphasis added):

"Investment promotion appears to be more effective in countries where English is not an official language and in countries which are more culturally distant from the US. Investment promotion also works better in countries with less effective governments, higher corruption and a longer time period required to start a business or obtain a construction permit. All of these findings are consistent with investment promotion alleviating problems associated with the scarcity of information and cumbersome bureaucratic procedures. Further, when we split the sample into industrialized and developing countries we find that investment promotion has a positive impact on FDI inflows in the developing world but not in industrialized countries. This is consistent with the observation that information and bureaucratic permits tend to be harder to obtain in a developing country setting. Finally, even within the subsample of developing countries, we confirm that investment promotion works better in places with higher information asymmetries and more red tape."

Obviously, this doesn't mean that IPAs are a substitute for institutional reform or infrastructure construction, but it does give hope that effective investment promotion can help bring in much-needed FDI while these important programs are still in progress. For example, if the transport system is inadequate for export manufacturing, it can be built with foreign investment if appropriate policies are adopted.

Almost all countries have at least one IPA. However, some are more effective than others. Evaluate your IPA from time to time, preferably by surveying its customers, and see if it needs improvement. If it isn't bringing in much FDI, perhaps now is the time to make this a priority. Growing Capacity can help.

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