South-South investment: development opportunities and policy agenda

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Worker in a factory in India. Photo - Ray Witlin / World Bank.The growing phenomenon of investment by developing country firms in other developing countries – sometimes referred to as ‘South-South investment’– offers significant development opportunities for the World Bank Group’s client countries. Obtaining a detailed picture of South-South investment flows and stocks is difficult because in many countries data on foreign direct investment (FDI) are inaccurate and insufficiently disaggregated. Still, the overall trend is fairly clear:
  • South-South FDI is seeing important growth. According to OECD stocktaking, the share of South-South FDI in total world FDI has grown from some 3% at the beginning of the century to around 14% in 2009. See the OECD’s Development Co-operation Report 2014
  • South-South FDI has stayed strong even as global FDI has been volatile. Despite a fall in FDI from OECD countries by 57% below 2007 levels in 2012, FDI from developing countries rose by 19 percent, according to the OECD’s Development Co-operation Report 2014.
  • South-South mergers can lead to economic upgrading. In 2013, over two-thirds of gross cross-border mergers and acquisitions by Southern multinational enterprises (MNEs) targeted partners in developing and transition countries, and half of these involved foreign affiliates of MNEs from developed countries passing their assets on to MNEs from developing countries, according to UNCTAD’s World Investment Report 2014.
 Policy agenda for developing countries
Though the growth in South-South FDI is encouraging, outward FDI remains a challenging proposition for many developing countries. From a macroeconomic perspective, domestic firms are needed to build the economy. When firms invest abroad, their home countries often consider it a loss of domestic capital, knowledge, and jobs. They have a hard time seeing what they gain.
 
From a microeconomic perspective, however, the domestic private sector flourishes when firms engage with international markets. When developing country firms invest in other developing countries, they tap larger markets, allocate their resources more efficiently, gain access to new resources and skills, and mitigate risk through diversification. They may also access strategic assets such as intellectual property, business models, and distribution networks.
 
MNEs from the South use distinct strategies to catch up with established players. Some evidence suggests that Southern MNEs understand local contexts more readily than their Northern peers and are better able to build South-South value chains. They may be more familiar with difficult business environments and institutions; they may have developed mechanisms allowing them to better navigate informality and red tape; and they may be better equipped to mitigate economic and political risks.
 
Policymakers should not underestimate the potential contributions of firm internationalization to development. Attracting FDI and connecting it to local businesses is just one way for developing countries to access the benefits of regional and global value chains. Promoting outward investment can be another way to integrate into the international economy.
 
Global policy implications of these dynamics
As outward FDI increases, some interesting matters of international regulation are bound to come up. For example, which policy instruments should countries be allowed to use to promote outward investment? How can the international community ensure that this promotion does not distort competition in national and regional markets? And how can countries ensure that outward investors channel back home some of the benefits of their growing businesses?
 
Trade and investment agreements can also impact the dynamics of South-South economic exchange. Some developing and emerging economies specifically use bilateral investment treaties (BITs) as instruments to promote outward investment, particularly investment in countries that suffer from fragility, governance challenges, and ineffective domestic court systems. For example, China has over the last years put in place around 130 BITs.
Increasing South-South investment relationships could also accelerate the formation of a rule-based system around investment issues that have historically been difficult to capture in a multilateral framework. The erosion of the North-South divide in investment matters is leveling the playing field and could mean that more countries may be interested in exploring such a multilateral regime.
 
Some Southern countries rely heavily on state-owned enterprises (SOEs) and state-affiliated investors to engage in strategic economic activities in partner countries. This use of sovereign investment offers chances to promote economic upgrading and competitiveness. At the same time, transparency in investment undertakings is particularly needed when investors have a sovereign background. Also, competition rules may need to be revisited in light of investments of SOEs to avoid a crowding out of private sector investors and to prevent market distortions.
 
Given the issues at stake, the development community needs to take a more detailed and comprehensive look at South-South FDI to understand drivers, economic conditions, and policy options for developing countries to foster investment exchange between them and leverage the potential of this phenomenon in a sustainable way.

Authors

Anabel Gonzalez

Formerly Senior Director, World Bank Group Global Practice on Trade and Competitiveness

Bertram Boie

Economist, Trade and Competitiveness Global Practice

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