Reviving FDI flows is crucial to economic recovery in developing economies

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The damage has been done: COVID-19 has dealt the global economy its most severe blow since the Second World War, causing the broadest set of synchronized recessions the world has seen since 1870. Emerging-market and developing economies have suffered unprecedented capital outflows—just when, as a group, they face their first outright recession in 60 years. 

Yet one key clear path to recovery is emerging amid the grim news: Developing economies must strive to restore and increase capital inflows, particularly in the form of foreign direct investment (FDI). FDI inflows have long been a key building block for developing countries, usually providing the largest source of external finance—more than official development assistance, or portfolio investment flows.  They will be crucial for a COVID-19 recovery.

Developing economies must strive to restore and increase capital inflows, particularly in the form of foreign direct investment (FDI).

FDI flows were already slowing before the COVID-19 outbreak amid rising protectionism and other uncertainties that eroded investor confidence. The pandemic added a new—and unprecedented—risk to the mix, sending business confidence to historic lows, and resulting in an expected decline of 40 percent in global FDI flows.

But reviving confidence is not an impossible task. A new World Bank report sheds useful light on what it might take to increase FDI flows. It notes that 2,400 business executives polled in 10 major emerging-market countries reported that low taxes, low labor costs, and access to natural resources matter less to their investment decisions than political and economic stability and a predictable legal and regulatory environment. In short, the top three drivers of FDI decisions are entirely within the control of governments. 

Policymakers in developing economies should seize the opportunity—as quickly as possible, as soon as the immediate health emergency is overcome. They have a chance to improve the long-term incentives for robust FDI flows to developing economies—which will emerge from the crisis heavily indebted and with limited fiscal space to pay for the reconstruction ahead. They have a chance to put in place complementary policies to ensure that FDI flows do not exacerbate inequality by benefiting mainly better-educated and higher-skilled workers.

Policymakers in developing economies should seize the opportunity—as quickly as possible, as soon as the immediate health emergency is overcome.

Reducing regulatory risk for investors has striking effects on FDI flows—even more than the effects of trade openness, our research shows. A one-percentage point reduction in regulatory risk tends to boost the likelihood of an investor entering or expanding in a host country by as much as 2 percentage points. By contrast, a one-point increase in the host country’s trade-to-GDP ratio boosts the likelihood by no more than 0.6 percentage point.

Given those effects, the World Bank has established a new global database for measuring regulatory risk.  It includes about 14,000 parent companies investing in nearly28,000 new and expansion FDI projects across 168 host countries. Its analytical framework focuses on the three items that investors most closely associated with lower regulatory risk—transparency, legal protection for investors, and investor access to grievance-recourse mechanisms.

Improving transparency and reducing bureaucratic discretion is an important first step for governments in developing economies. This can make the business outlook more predictable and less risky for companies. Governments can strengthen transparency by consulting systematically with the private sector and other stakeholders. They can develop information portals to make laws and regulations publicly accessible. They should articulate clear and specific FDI-related legal provisions and administrative procedures.

Improving transparency and reducing bureaucratic discretion is an important first step for governments in developing economies.

Investment competitiveness and good governance were important markers of progress for developing countries long before the crisis began. COVID-19 has elevated their urgency.  The magnitude and scale of the crisis require policy makers to employ their full arsenal of policy tools to rebuild investor confidence. They should rise to the occasion—by acting quickly, decisively, and collaboratively.

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Gumisiriza Modern
June 22, 2020

Developing need foreign direct investment for their economies to thrieve since they can easily get foreign assistance.

Peter McDermott
June 22, 2020

This blog and the findings of the Global Investment Competitiveness Report 2019-2020 that it highlights are of significant, well-timed value. They need to be essential reading for investment attraction policy makers and IPAs worldwide. Congratulations to everyone involved.
May I make two observations. First, the issue of the potential alignment of national FDI-related regulatory regimes across geographic regions has been discussed over some time as a means of boosting cross-border investment, particularly to low income destinations. There are, of course major barriers to overcome, not least the competitive instincts and political climates of independent countries. And the recent flurry of uncoordinated protectionist measures being adopted around the world has put back the possibility of any international harmonisation initiatives being discussed by some years.
I should add that the irony of the UK currently resisting broader regulatory alignment with the EU is not lost on me.
But I hope that the World Bank and other leading international institutions will keep the topic of FDI-related regulatory alignment on their agendas, impossible though that vision might be at the moment.
My second comment is really a cri de coeur from an aging FDI specialist. It concerns developing the capacity of IPAs. By capacity I mean the key enabling factors of leadership, culture, individual/team capability, resources and external framework. A strong capacity plainly increases the ability of agencies to operate as closely to a best practice level as possible so that they can maximise investment opportunities and reduce the impact of threats – relevant both in the immediate aftermath of the current pandemic and beyond.
Over many years huge amounts of resource have gone into IPA capacity assessments, strategy development and skills training, much of it provided to low-income countries via aid agencies. There has also been a good flow of advisory content from the World Bank, OECD, UNCTAD, WAIPA and others. The private sector has also provided significant training input.
In my experience many of the IPAs that have received capacity development support in the past – particularly those with limited resources and who face tough challenges – still operate far below best practice. I think that the main reasons for this are the short-lived effect of initial training; insufficient resources for sustained follow through; rapid staff turnover in the agency; and a weak continuous improvement culture.
The other issue is that costly development content produced for one IPA is rarely re-used or made available to others. Even the main aid agencies appear not to have a central, free-access library of training and development. This is not just wasteful – it is contributing to the inability of deprived business locations to work towards achieving their economic growth potential.
It can be argued that a much more co-ordinated, collaborative approach to IPA capacity building is needed across the foreign direct investment stakeholder community. This means moving beyond the largely ‘here today, gone tomorrow’ dispersed style of capacity development that has been the norm so far – though this will always exist – to the creation of an open-access knowledge and skill sharing resource. Another impossible dream perhaps?