Chapter

IV Policies of Host Developing Countries Toward Foreign Investment

Author(s):
International Monetary Fund
Published Date:
January 1985
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Most developing countries combine some degree of regulation of direct investment, aimed at improving their net benefits, with various incentives designed to attract it. During the 1960s and much of the 1970s there was a general trend toward greater restrictions: alternative forms of external financing were more readily available, there was disappointment with some of the results of previous direct investment, and nationalist sentiment in many countries was growing. A number of developing countries also restricted foreign portfolio investment in securities of domestic enterprises. In recent years, however, some countries have adopted more flexible policies, partly because of the need to bolster weakening external economic and financial positions. This section will discuss these policies, as well as the effects of some of the principal restrictions and incentives adopted in many developing countries. In discussing such policies, however, it should be remembered that the provision of a stable economic environment and the adoption of appropriate financial and exchange rate policies may be even more important for encouraging foreign investment and for increasing net benefits to the host country than policies related specifically to promoting such investment.

Although the combination of policies chosen depends to a large extent on a country’s development strategy and market philosophy, its underlying attractiveness as an investment location is also important since this affects its relative bargaining strength vis-à-vis potential direct investors. Factors such as the size of the domestic market, the potential for export-oriented production, and natural resource endowments all influence the combination of regulatory and incentive policies that is adopted. As has already been noted, a number of countries (particularly in Africa and the Caribbean) with small domestic markets and limited natural resources were unable to attract significant inflows of direct investment during the 1970s, despite offering substantial incentives. However, a few countries with relatively small domestic markets (including Hong Kong, Singapore, and, to some extent, Malaysia) that pursued open economic policies and maintained few restrictions on foreign investment were able to attract substantial export-oriented direct investment, while generally offering only moderate incentives. In contrast, many countries with larger domestic markets (including India, Nigeria, and most of the larger Latin American countries) and consequently with greater potential for attracting direct investment for import-substituting production, imposed a number of restrictions or specific performance requirements to extract greater benefits. These restrictions were usually combined with various incentives, so that direct investors faced a complex set of signals that sometimes differed substantially from prevailing market prices.

In many instances, the screening or regulation of direct investment may have improved a host country’s bargaining position and contributed to a greater political acceptability of such investment. However, the complicated mixture of incentives and disincentives sometimes made it difficult to evaluate the overall net contribution of direct foreign capital. Nevertheless, although various restrictions and regulations often acted as a barrier to new investment, they were not always insuperable for countries that offered an attractive location. In some cases, complexity and frequent changes in regulations may have been a greater disincentive than the existence of rigorous, but stable and clearcut, controls.

Restrictions

Many developing countries restrict foreign investment in certain sectors, either on the grounds of the political sensitivity of certain industries (especially public utilities, broadcasting, publishing, banking, and the petroleum industry), or to reserve for local enterprises those industries with relatively simple technical and financial requirements (such as the retail and wholesale trade).17 Some countries (such as Nigeria) have established comprehensive lists of industries and their permitted degree of foreign participation, which varies according to an industry’s technological complexity and capital requirements; others have drawn up lists of priority industries in which foreign investment would be welcome and where it is often eligible for special incentives.

The permitted degree of foreign ownership of all enterprises is also limited in many countries and the takeover of existing local firms is prohibited except in special circumstances. A number of countries (including India, Mexico, the Philippines, Yugoslavia, and most centrally planned economies) generally require that foreign investors hold only a minority equity participation in enterprises, although most allow majority or even full foreign ownership in some high priority industries or where production is mainly for export. In some cases, foreign companies are required to release ownership and managerial control gradually through the sale of shares to residents over a specified period; such “dilution” requirements are incorporated into the common regime for foreign investment of the Andean Pact countries and are also a major element of foreign investment policies in India and Nigeria.

The economic case for restricting the scope of foreign capital in particular sectors is similar to that for the protection of “infant” industries. Such restriction promotes domestically-owned enterprises that may eventually be able to compete on equal terms with foreign enterprises, but with initial welfare costs, in terms of higher prices or lower quality. But attempts to restrict or dilute the share of foreign ownership may create substantial disincentives to foreign investment in high technology industries, where firms are especially concerned to protect proprietary information; a number of foreign firms have withdrawn when faced with such situations (for example, in India). Nevertheless, some countries (such as Mexico) which have fairly strict rules on foreign ownership are still relatively successful in attracting direct investment. Limitations on the proportion of foreign participation in particular industries are likely to reduce foreign investment less than outright sectoral limitations. Perhaps a greater danger is posed by a country’s attempts to accelerate unduly the takeover of foreign firms before domestic enterprise is in a position to take their place. For instance, the program to encourage a rapid local takeover of many foreign-owned enterprises in Zaire during the early 1970s led to a substantial decline in productivity as well as a loss of foreign investment inflows. It was later partially reversed.

Remittances of interest and dividends on direct investment as well as fees for technology transfers are subject to restrictions in various developing countries. Some countries impose restrictions as part of their permanent direct investment policies; some (including the Andean Pact countries and Greece) limit remittances to a certain percentage of invested capital; while others make overseas dividend transfers subject to additional taxation or limit them to a proportion of the firm’s foreign exchange earnings. Yet other countries have imposed temporary restrictions on transfers of profits and royalties as part of broader exchange restrictions when faced with serious external imbalances. Both permanent and temporary restrictions are obvious major disincentives to new investment and are also likely to encourage disguised remittances through artificial transfer prices that would reduce the host country’s share of profit tax receipts. Moreover, dividend remittances are sometimes subject to greater restrictions than interest payments on loans; this may encourage an excessive debt/equity leverage in an affiliate’s capital structure.

A growing number of countries impose specific performance obligations on foreign-owned firms, most frequently in the form of requirements for either a minimum level of exports or a given share of domestic content in total output (such regulations are applied, for instance, to the automobile industry in most Latin American countries). Other countries impose no specific requirements on foreign firms, but set conditions on access to various incentives according to a firm’s performance with regard to exports or domestic content. Such arrangements raise the costs of foreign investors, by requiring them to engage in presumably unprofitable activities in order to gain access to the local market. They are similar to trade restrictions, in that they create an implicit subsidy to exports and import substitution, and have similar disadvantages, in that they distort resource allocation, can lead to the development of an inefficient industrial base that is unable to compete without such protection, and can invite trade retaliation.

The access of foreign-owned firms to local capital markets is restricted in many developing countries (including Argentina, Kenya, Nigeria, Peru, the Philippines, and Turkey). Such a restriction is often needed as part of wider controls on capital movements, as the authorities attempt to insulate the domestic financial system to maintain noncompetitive interest rates. Without a restriction on local borrowing, interest rates below those consistent with equilibrium in the local financial market could lead to a crowding-out of domestic enterprises and a net capital outflow, because of the generally greater creditworthiness of foreign firms. However, all such selective credit restrictions can have costs in terms of distorted allocation and reduced productivity of investment, while low interest rates may contribute to the substitution of foreign for domestic savings.

Many developing countries have also imposed restrictions that hinder foreign portfolio investment. These include outright prohibition, restrictions on the types of shares in which foreign investment is allowed, limits on capital repatriation, lengthy minimum investment periods, and taxes on dividends and capital gains that are often well above international averages. Until recently, only a few countries (but including Jordan, Malaysia, the Philippines, Singapore, and Thailand) could be considered to have tax and foreign exchange arrangements conducive to foreign portfolio investment.18 In addition, such investment was also frequently deterred by complex administrative arrangements, lack of adequate reporting requirements on company performance, as well as by the narrowness of securities markets in many developing countries, which greatly reduced the liquidity of investments and the possibilities for spreading risks over a diversified portfolio. The narrowness of the market for equities was often exacerbated by government policies, such as tax systems that discriminated against equity investment and restrictions on equity purchases by domestic institutional investors.

Although it is difficult to characterize global trends in policies toward direct investment, since in some cases restrictions have been tightened, recent trends in a number of countries have been toward liberalizing policies to attract more foreign investment. This was partly due to increased external financial constraints faced by many of these countries, but also reflected a greater confidence in the potential benefits of foreign investment—to some extent as a result of investors” greater willingness to adopt arrangements such as joint ventures and minority equity participation that suited host country sensibilities. Some countries (including Egypt, Jamaica, the Philippines, and Turkey) have shifted from detailed control of direct investment to much more flexible arrangements, while more gradual policy changes have taken place in other countries (including Korea, Mexico, Morocco, and Pakistan). A few countries have also introduced some relatively modest provisions to encourage the conversion of outstanding external debt into equity investments. Turkey allowed claims arising from nonguaranteed trade arrears to be used for direct investment during 1980–82, and these claims financed a large proportion of new foreign direct investment over the period; a similar arrangement was available in Indonesia, while Brazil granted a tax credit for nonresidents converting their loans into investment during 1983.19 A few countries also relaxed controls on foreign portfolio investment. Korea has announced a program of gradual liberalization of its securities market, beginning with the establishment of international investment trusts on a limited basis; and Brazil has substantially reduced the minimum investment period for foreign portfolio investment.

The policies of some centrally planned economies toward foreign direct investment have also been modified in recent years. A number of countries (including Hungary and Romania) have permitted the entry of foreign capital through joint equity ventures, generally with minority foreign equity participation. The greatest change in policies has been in China, which now encourages investment either through joint ventures or through wholly-owned foreign enterprises, and has also concluded a number of important agreements for foreign participation in offshore petroleum exploration. In 1984, China also announced new, more favorable treatment for foreign direct investment in 14 coastal cities, including a liberalization of regulations governing the purchase of inputs and the sale of a proportion of output on the domestic market.

Incentives

Many developing countries use a complex set of direct and indirect incentives to attract foreign investment. Most can be classified as offering either commodity protection, which alters the prices of goods and services bought or sold by a firm (such as tariffs and quotas on imported competing products and exemptions from import duty on inputs), or factor protection, which alters the prices of the inputs of production employed by a firm (factor protection might consist of tax holidays, investment allowances, and subsidies for the training of local labor).20 The type and size of incentives offered by a country depend on the market orientation of the investment it wishes to attract and on the degree of competition it faces from other countries in attracting that type of investment. For instance, direct investments can be oriented toward production for a common market among a group of developing countries, for worldwide export, or for the domestic market of the host country. Competition to attract direct investment tends to be the most intense among members of a common market and the least intense for investment oriented toward a single domestic market. Incentives involving factor protection are more important among members of a common market and for countries concerned with attracting export-oriented investment, while commodity protection (particularly protection from competing imports) is more important for countries primarily concerned with attracting investment to serve the domestic market. For example, it has been estimated that for a large developing country in the latter situation, commodity protection accounts for more than 80 percent of the total incentives provided.

The variety and complexity of incentives make it difficult to evaluate their effectiveness. Incentives matter in the sense that an individual country might stand to lose much new direct investment were it to abolish all its incentives unilaterally. For example, a detailed investigation of the location of new investment in a cross-section of developed and developing countries concluded that in two thirds of the cases analyzed, the choice of country for the investment was influenced by incentives provided, in the sense that the investment would have been located elsewhere without the incentives. It is less clear, however, that a country can attract significantly more direct investment by small increases in its existing incentives, especially if such increases were matched by other countries competing for the same investment.21 Moreover, there are strong indications that incentives become less effective the more complex they are and the more frequently they are altered, since such factors increase the information costs and uncertainty facing potential investors. Given that incentives can be costly, in terms of either foregone fiscal revenues or the costs of increased protectionism, a group of countries may benefit from an agreement to limit competition in granting incentives. A number of such agreements have been concluded among groups of developing countries that are members of common markets (including the Andean Common Market and the Caribbean Community, CARICOM, where the risk of such competition is greatest.

Finally, administrative procedures concerning foreign investment in developing countries can be a major deterrent to investment. Efforts to adapt and streamline these may do more to facilitate such investment than moderate improvements in tax and other incentives. Some countries have already begun such efforts, at times (as in the case of Korea) through the establishment of one-stop service centers for potential foreign investors to assist them with necessary clearances, licenses, and legal referrals.

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