Since the onset of the debt problem in the early eighties, developing countries have been in the grip of a deep and protracted economic crisis. For them the decade of the eighties has been aptly described as a lost decade as their standard of living suffered stagnation or even deterioration. Most of them have incurred unsustainable external deficits and experienced high rates of inflation, crushing debt-service burdens, and sluggish growth in gross domestic product (GDP). Part of their woes is undoubtedly ascribable to an unfavorable external environment, notably, mediocre growth in the industrial countries, a rising tide of protectionism, stagnation of financial flows, and worsening terms of trade. While these factors are important, they fail to offer a satisfactory explanation. A good part of the blame lies with domestic factors. In a large number of cases poor economic management is responsible for widespread macroeconomic and structural distortions and for failure to implement timely and effective programs of adjustment in the face of deteriorating external conditions.

Since the onset of the debt problem in the early eighties, developing countries have been in the grip of a deep and protracted economic crisis. For them the decade of the eighties has been aptly described as a lost decade as their standard of living suffered stagnation or even deterioration. Most of them have incurred unsustainable external deficits and experienced high rates of inflation, crushing debt-service burdens, and sluggish growth in gross domestic product (GDP). Part of their woes is undoubtedly ascribable to an unfavorable external environment, notably, mediocre growth in the industrial countries, a rising tide of protectionism, stagnation of financial flows, and worsening terms of trade. While these factors are important, they fail to offer a satisfactory explanation. A good part of the blame lies with domestic factors. In a large number of cases poor economic management is responsible for widespread macroeconomic and structural distortions and for failure to implement timely and effective programs of adjustment in the face of deteriorating external conditions.

The same can be said of the majority of Arab countries. For countries such as Algeria, Egypt, Morocco, the Syrian Arab Republic, Sudan, and Tunisia, the decade of the eighties was marked by poor economic performance as reflected in substantial external and internal imbalances. For the oil-rich Arab countries, as might be expected, it was somewhat different. With the sharp increase in oil revenue, they were able to make remarkable progress. However, the later debacle in the oil market gave rise to a wide range of economic problems. In this group of countries, as in the rest, adjustment to a changed economic environment has become imperative.

Against this background, the Arab Fund for Economic and Social Development and the Arab Monetary Fund, in cooperation with the International Monetary Fund and the World Bank, convened a seminar on “Investment Policies in the Arab Countries.”

There are two ways in which the term “investment policies” can be interpreted. In a narrow sense, investment policies refer to those policies specifically designed to strengthen incentives and eliminate impediments that impinge on investment decisions. In this sense investment policies cover such topics as tax holidays, investment guarantees, and free zones. Broadly interpreted, however, investment policies refer to the investment climate, that is, the totality of policies and institutions that have a bearing, directly or indirectly, on investment decisions. In this sense there can be no meaningful discussion of investment policies without reference to the macroeconomic and microeconomic policies of the country concerned. Investment policies are intimately intertwined with monetary, fiscal, and trade policies in addition to questions related to banking institutions, legal and judicial systems, labor and tax laws, as well as regulatory arrangements.

At the seminar that took place in Kuwait on December 11–13, 1989, investment policies were tackled on the basis of both a narrow and a broad interpretation. Eight papers were discussed.

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In addition, written comments on these papers were prepared by designated discussants, and general remarks by Ibrahim F.I. Shihata on the encouragement and promotion of foreign and Arab investment were circulated.

It is neither feasible nor useful to summarize the content of all papers, as they cover such a vast and complex area. An attempt will be made, however, to highlight some of the recurrent themes in the seminar.

The Macroeconomic Impact

One of the major themes in the seminar was the impact of macroeconomic policies on investment. As pointed out earlier, macroeconomic policies constitute one of the important determinants of the investment climate. Not infrequently, the investment climate in developing countries, including Arab countries, is vitiated by macroeconomic distortions. Substantial budget deficits, overvalued exchange rates, and negative real interest rates are typical of such distortions. Insofar as a budget deficit is financed through money creation, as often happens, it becomes a major source of inflation. Inflation militates against the investment climate. It undermines confidence in the national currency, weakens the incentive to save, encourages unproductive forms of investment such as holding foreign currency deposits and inventories, and causes capital flight. Part of the budget deficit is financed by borrowing from the local market. In countries like Algeria, Egypt, and the Syrian Arab Republic, for example, a good portion of domestic savings is under the control of pension funds, social security funds, and insurance companies. Since they are all public sector institutions, the government avails itself of their financial resources to cover part of the budget deficit. This form of financing may not be inflationary, but it can have a detrimental effect on the quality of investment by crowding out productive private sector projects in favor of less efficient public spending. Thus, a certain portion of productive investment is pre-empted by this type of financing of the budget deficit.

Overvalued exchange rates exercise a similar impact on investment. They inhibit the inflow of capital and induce the outflow of domestic savings. By cheapening imports artificially, overvaluation of national currency encourages investments with a high foreign exchange component. The same can be said of negative real interest rates, which go a long way toward explaining the phenomenon known as the “dollarization” of the national economy, reflected in the widespread recourse to foreign currency deposits by residents whenever it is legally permissible. Simultaneously with dollarization, negative real interest rates are behind a good deal of capital flight from developing countries. These distortions deprive developing countries of badly needed domestic savings. No less important is that negative real interest rates encourage the use of capital-intensive techniques of production in countries with an abundant supply of labor. Worse still is that they virtually eliminate the cost of capital as a means of rationing credit among competing users. Under conditions of negative real interest rates, the mere fact of securing credit becomes a source of windfall profit. As a consequence, demand for credit at prevailing interest rates tends to outstrip the supply of savings. Since interest rates are not allowed to rise in response to market forces, the only way of achieving equilibrium between supply and demand is through direct allocation of credit among potential investors. The amount of waste involved in this method of allocation can be substantial. There is no guarantee that credit goes to investments with the highest rate of return. Moreover, when the banking system is itself part of the public sector the method of direct allocation is sure to result in further crowding out of the private sector.

It is important to point out that macroeconomic distortions are interrelated. Budget deficits and excessive credit expansion lead to inflation, which underlies negative real interest rates and overvaluation of currency. By giving rise to the phenomenon of dollarization and by inducing capital flight, negative real interest rates intensify pressure on the national currency and can be a significant factor in the overvaluation of exchange rates. Thus, the economy slides into a vicious circle where each macroeconomic distortion feeds, and is fed by, the other. The combined effect of this vicious circle thoroughly distorts the investment climate.2

The preceding analysis applies to many Arab countries. It is particularly true with respect to macroeconomic policies in Egypt and Morocco.3 The case of Iraq is somewhat different. For the major part of the post-Second World War period, investment was almost completely dependent upon oil revenue, which accounted for an overwhelming proportion of public revenue. Foreign borrowing, up to the outbreak of the war between Iraq and the Islamic Republic of Iran, was conspicuous by its absence. Tax revenue as well as private domestic savings played a minor role as a source of financing investment. While stability of the price level was always a matter of concern for the Government, neither exchange rates nor interest rates played an important role as instruments of investment policy.4

Microeconomic Distortions

The efficiency of investment is largely, but not exclusively, determined by microeconomic considerations.5 In many countries a great deal of waste is accounted for by distortion of relative prices. Prices of a wide range of goods and services are typically subject to strict administration controls. Accordingly, they fail to respond to changes in market forces, and when they do, it is usually too little and too late. After a certain period of time during which market forces are ignored, prices cease to reflect the relative scarcity of resources, that is, they cease to be economic prices and become social or political prices. Three types of price distortions can be identified.

  • Deviation of domestic prices from international prices. In some instances, domestic prices are well above international prices. This is true of heavily protected industries where protection takes the form of exceedingly high tariffs together with quantitative restrictions and other nontariff barriers. This type of distortion injects a bias against export industries and in favor of import-competing industries. As a consequence, investment resources are artificially diverted from the more productive export industries to the less productive but more profitable import-competing industries. In other instances, domestic prices are well below world prices. This is the case for industries whose output enters as input in the import-competing industries (for example, energy) as well as those whose output is subject to a government monopsony making profit from the differential between domestic and international prices (for example, cotton in Egypt). Here again the allocation of investment resources on the basis of artificial prices falls short of the optimum pattern that would otherwise have prevailed.

  • Divergences in price-cost relationships. This type of distortion arises because the incidence of government controls is uneven owing to administrative weaknesses and because different goods and services are not subject to the same rules and regulations. In the political scheme of things, some goods and services are more important than others. Consequently, some prices are fixed while others are left to find their own level following changes in market forces. In due course relative prices become divorced from relative costs with the result that certain investments become highly profitable compared with others, not because of the interaction between supply and demand but because of the uneven incidence of government policy. This consideration explains why in Egypt there is less than optimum investment in the production of cotton, which is subject to a system of compulsory delivery at artificially low prices, and more than optimum investment in the production of fruits, the prices of which are left free. It also explains why there is a scarcity of housing for rent, which is subject to strict controls, and an abundance of housing for sale, which is unrestricted.

  • Multiplicity of prices for the same commodity or service. In many instances there is no single price for, say, sugar or wheat flour, but many prices for different categories of users. There is one price for sugar used by candy factories and other prices for different groups of consumers according to their presumed income levels. The same applies to wheat flour, where there is one price for making bread, another for making pastry, and there is also differentiation according to whether the buyer is a public or a private sector entity. This type of distortion is a common phenomenon and has the effect of destroying the price mechanism as a means of allocating investment resources.

Efficiency of Public Investment

In many Arab countries a high proportion of investment is accounted for by the public sector. This is true for Algeria, Egypt, Sudan, the Syrian Arab Republic, and the People’s Democratic Republic of Yemen. In these countries public investments are as high as 70 percent or more of total investment. In other Arab countries the proportion of public investments is not as high but is still important.

In countries with a high proportion of public investment, public enterprises dominate a wide range of economic activities. Banking, insurance, foreign trade, the modern manufacturing sector, mining, construction, public utilities, transport, and many other activities are typically under the sway of public enterprises. The rationale for this state of affairs varies from one country to another. In some cases, the government of the day opted for a socialist orientation based on public ownership of the means of production or a drive to control the so-called commanding heights of the economy. In others, the explanation lies in pragmatic considerations such as the appropriation of surpluses or the absence of a private sector willing and able to undertake major projects.

Whether ideological or pragmatic, the dominance of the public sector was expected to make a positive contribution to development. The experience of the past twenty years or so seems to point in the opposite direction. The performance of the public sector in developing countries has been the subject of extensive studies. These studies are virtually unanimous in concluding that the results have been far from satisfactory. Performance was measured in terms of several indicators: overall deficits, impact on the government finances, rate of return on capital invested in public enterprises, impact on the balance of payments, and share of external indebtedness. It was found that, with a few exceptions, the public sector incurs substantial losses, contributes significantly to budget deficits, earns exceedingly low rates of return, has a negative impact on the balance of payments, and is responsible for a good part of external indebtedness.

The first step in reforming the public sector is to recognize the constraints set by the managerial capacities of the countries concerned. In many developing countries evidence shows that the public sector is overextended and that the proper role of the government needs to be redefined on the basis of a realistic assessment of development imperatives as well as of available financial and administrative resources. It is equally well recognized that under conditions of underdevelopment the state will continue to play an important economic role This situation is unavoidable given the limitations imposed by small domestic markets, lack of factor mobility, weakness of the private sector, and, above all, imperfections of the market. However, the present scope of the public sector typically goes far beyond what is justifiable in terms of these considerations. It is difficult to justify that in many Arab countries, the government continues to be involved in such activities as grocery and department stores, bakeries, flour mills, printing, bookshops, advertising, hotels, travel agencies, contracting, cattle and poultry farming, fisheries, and scores of other activities. These are normally the kinds of activities that are better and more effectively undertaken by the private sector.

At the other extreme there are activities that constitute the core of the public sector. They include the traditional role of government in health, education, defense, maintenance of law and order, as well as the macroeconomic management of the economy. To a large extent the public sector should also continue to be involved in the provision of basic physical infrastructure including roads, water supply, telecommunications, electricity, flood control, irrigation, and sanitation facilities.

Between these two extremes a vast gray area exists about which it is difficult to generalize.6 The proper mix between the public and private sector is a matter that varies from one country to another depending on the stage of development as well as the availability of private capital and entrepreneurship. It is important, however, to keep in mind that there are limits to what the public sector can do and that excessive involvement in the production process is certain to be at the expense of those services that only the government can provide. As John Wall puts it, “Spending too little on basic government services while spending too much in areas that the private sector could have served is perhaps the biggest and most costly loss of efficiency. …”7

Apart from the proper mix of the public and private sector, economic performance suffered greatly because governments tend to saddle public enterprises with mixed mandates, including social objectives that often conflict with considerations of efficiency. Public enterprises have been required to play a role in the implementation of government policy of guaranteed employment to university graduates. This policy meant that they were forced to appoint annually a certain number of candidates allocated by the government although there were no jobs for them to perform. The policy of guaranteed employment has had a profoundly adverse effect on the performance of public enterprises. Not only has it resulted in swelling the ranks of disguised unemployment, but more important, it has undermined the work ethic, created intolerable working conditions, and inflated the wage bill with nothing to show for it.

Public enterprises were also required to contribute to the antiinflationary policy by holding down the prices of goods and services they produced. The policy is thought to protect the low-income groups by offering essential consumer goods at reasonable prices. The result is the opposite of what is intended. It was not possible to hold down prices without heavy subsidies from the government budget. In due course subsidies became a major factor in the budget deficit, which is itself the principal source of inflation. The adverse effect of inflation on income distribution is too well known to warrant elaboration. Nor has this policy succeeded in achieving the objective of helping the low-income groups. Most of the benefits of open-ended subsidization have in fact accrued to petty middlemen, corrupt officials, and higher-income groups with much better access to supplies than the targeted groups.8

The policy of mixed mandates has been costly in terms of efficiency. It has inevitably resulted in pervasive cost-price distortions and, consequently, considerable misallocation of resources. No less important, it has compelled the government to protect public enterprises from competition as a means of generating rents to pay for the social burdens. They were protected from foreign competition by extensive tariff and nontariff barriers. At the same time, domestic competition was frequently thwarted by a system of licensing designed to control new entry, especially of private firms.

In the light of these considerations it is incumbent that the policy of mixed mandates be discontinued. Evidently, unemployment cannot be dealt with through a policy of guaranteed employment in public enterprises. There is no substitute for a growing economy that could provide adequate opportunities for productive employment. Similarly, interference with the price system is an ineffective and inefficient tool to protect vulnerable consumers. If prices are to perform their principal function of resource allocation, they have to be responsive to market forces and reflective of relative scarcities. This is not to ignore considerations of social equity, which is better served through the taxation system.

This analysis points clearly to the nature of reform. Public enterprise should be allowed to operate on the same basis as the private sector. Efficiency and profitability in a competitive environment should be the sole criterion by which performance is assessed. It remains to be seen whether this expectation is realistic given the history of the public sector over the last twenty-five years.

Role of Foreign Investment

So far foreign direct investment has played a minor role in the economic development and the adjustment process of capital importing Arab countries. Like other developing countries during the seventies, the Arab countries resorted to foreign borrowing to meet their external financing requirements. For a variety of reasons, foreign borrowing rather than foreign direct investment was the preferred form of financing. Newly independent countries that had just emerged from a long period of colonial domination were anxious to maintain control over their own economic and political affairs. Foreign direct investment that was in the majority of cases closely associated with multinational companies was perceived to be incompatible with this goal. There was also a tendency to discount the presumed advantages of foreign direct investment compared with other forms of financing. Not infrequently multinational corporations were not interested in developing export-oriented industries but rather in supplying the home market behind a high protective wall. The impact on employment was seen as minimal in view of the capital-intensive techniques imported from the home country; the transfer of technology was seen as a mirage as multinational corporations were secretive about their methods of production, and training of local personnel was kept within the narrowest possible limits. Equally important was concern about the distribution of benefits between the host country and the investing corporations in terms of tax revenue, value added, and reinvested profits. The prevailing view in most developing countries was that through dubious methods and practices such as transfer pricing, multinational corporations arrogate to themselves the lion's share of the benefits from investment.

These were some of the considerations behind the relative decline in the role of foreign direct investment during the seventies. The trend was abetted by the fact that borrowed funds were readily available. After the sharp increase in oil prices, a large proportion of world savings shifted to the oil exporting countries. These countries were either unable or unwilling to undertake direct investment abroad on a significant scale. Most of their savings were kept in deposits with commercial banks in the industrial countries and became available for lending to developing countries that were only too happy to use this source of financing. For the first time commercial banks emerged as a major source of lending to developing countries. This development obviated to a large extent the need for foreign direct investment.

In contrast to the sixties and seventies, the decade of the eighties saw a revival of interest in foreign direct investment. On the part of multinational corporations an effort was made to establish standards for acceptable business conduct. They became more sensitive to the concerns of developing countries and more flexible in the particular forms of investment. This change included a greater willingness to accept innovative arrangements such as joint ventures, turnkey projects, build-own-transfer (BOT) arrangements, and licensing agreements rather than the traditional wholly owned subsidiary. Developing countries, on the other hand, became more experienced and confident in dealing with multinational corporations. Moreover, they can, if they so wish, receive assistance and advice in negotiations with multinational corporations from institutions established within the framework of the United Nations and its specialized agencies such as the UN Centre on Transnational Corporations and the Investment Promotion Service (IPS) of the United Nations Industrial Development Organization (UNIDO).

The most important factor, however, underlying the changed attitude toward foreign direct investment is the recent developments in the international financial system. The debt crisis of the early eighties has underscored the serious limitations of heavy dependence on foreign borrowing. A heavy debt-service burden combined with variable interest rates on a large proportion of their debt made the heavily indebted countries particularly vulnerable to external shocks. A prolonged recession in the industrial countries, in addition to the high cost of energy and the collapse of prices of principal export commodities, have conspired to undermine their payment capacity. The result was a debt crisis of unprecedented severity, which inflicted untold hardships on the indebted countries and threatened their growth prospects—not to mention the integrity of the international credit system. In contrast, remittances of dividends and profits on foreign direct investment are much more responsive to changes in business conditions. By their very nature they increase with prosperity and fall with recession. They are more in tune with changes in the payment capacity of the host country. More important, the debt crisis has had a profound impact on the international sources of finance available to developing countries. Commercial bank lending has all but dried up not only for balance of payments support but also for project financing. Most commercial bank lending is presently undertaken in the context of adjustment programs supported by the International Monetary Fund. Outside this type of concerted or “involuntary” lending, most is limited to collateralized or guaranteed loans. Other sources of finance are also subject to severe constraints. The tight budgetary situation in most industrial countries has been a serious obstacle to expanding bilateral sources of finance whether concessional or nonconcessional.

Moreover, recent developments in the socialist countries of Eastern Europe are certain to give rise to an enormous demand for external financing from the major industrial countries, which could easily impinge on the financial resources available to developing countries. This situation leaves the multilateral sources of finance, particularly the World Bank and the International Monetary Fund, as a possible alternative. But it is clear that even under the most optimistic assumptions on the growth of their capital base, these institutions cannot play the role of commercial banks in international financing.

Such dim prospects for other sources of external financing are likely to enhance the role of foreign direct investment and raise a number of issues about the most appropriate policies to attract and maximize the benefit from it.

Incentives, Restrictions, and Guarantees

The first issue relates to the relative importance of macroeconomic policies and special incentives as factors in attracting foreign investment. It was pointed out earlier that macroeconomic policies are highly relevant to investment decisions. This is particularly true with respect to foreign investment. Empirical investigation shows that a stable macroeconomic environment is perhaps the most important single factor in the calculations of the foreign investor. High rates of inflation, overvalued currency, sudden and sharp devaluation, administratively fixed interest rates, or a weak banking system are not the kind of conditions that attract foreign investment.9 In this context it is important to note that some countries have succeeded in attracting a considerable volume of foreign investment on the basis of a stable macroeconomic environment although they have little by way of natural resources and only limited special incentives. To this category belong countries such as Hong Kong, Singapore, Taiwan Province of China, and the Republic of Korea. In some other countries, by contrast, generous incentives have failed to attract significant foreign investment because of macroeconomic distortions. Egypt is a case in point. Law No. 43 of 1974, recently replaced by Law No. 230 of 1989, offers advantages, exemptions, and guarantees that are virtually unequaled by other developing countries of comparable development potential. However, the impact on foreign investment has been extremely limited.10

It is also important to note the relationship that exists between macroeconomic distortions and incentives. To compensate for the disadvantages arising from macroeconomic distortions, host countries are likely to offer incentives in various forms. The deeper the distortions, the more extensive are the incentives. But incentives are not without cost to the host country. Often foreign investors are exempt from all forms of taxes, duties, and fees for periods that could extend for 10 and 20 years. Expansion of capacity is similarly exempt even if it takes place long after the expiry of the original period. The loss to the treasury could be considerable. At the same time, this method of attracting foreign investment weakens the fragile foundation of the taxation system, encourages tax evasion, and discriminates between different types of investment. In the light of experience it might be concluded that tax exemptions and similar incentives should be used selectively to compensate for externalities that interfere with the optimum flow of investment.

Debt-equity swaps provide another type of incentive for the promotion of foreign investment in the heavily indebted countries. They are dual-purpose instruments, as they serve both to reduce the size of outstanding foreign debt and to increase the volume of equity and direct investment. This policy is predicated on three basic assumptions.

  • The existence of a foreign debt owed to commercial banks or private creditors with a secondary market in which debt instruments are traded at less than their face value.

  • A potential investor—whether foreign or national—who is interested in making equity or direct investment in the indebted country and who buys a debt instrument at a discount in the secondary market.

  • A government that is prepared to allow the holder of the debt instrument to sell it against local currency and to use the proceeds of the sale in equity or direct investment.

If these assumptions are satisfied, each party to the debt-equity transaction will have an incentive to proceed with the deal. The creditor commercial bank has the incentive to sell the debt at less than face value to clear its books of nonperforming assets. The potential investor buys an instrument whose face value is more than it costs to acquire it. The government of the debtor country—or the central bank—has the incentive to reduce the stock of outstanding debt at no cost in foreign exchange while promoting foreign investment.

A number of indebted countries, particularly in Latin America, have undertaken debt-equity swaps, with varying degrees of success.11 The heavily indebted Arab countries could benefit from similar programs if they are well designed. A question that arises in this context is the type of investment that would be allowed under the program. In some countries investments are limited to pre-designated priority sectors while others exclude such investment activities as the acquisition of stocks in existing companies, buyouts, and financial restructuring. Another question is the rate of exchange that is applicable to the conversion of the debt instrument into local currency. There are various approaches to this issue aimed at dividing the benefit of the discount between the government and the potential investor. Finally, there is the question of control over the pace of debt-equity swaps to avoid aggravating inflationary pressures from excessive growth in money supply. The Egyptian Investment Law No. 230 of 1989 contains provisions that permit debt-equity conversions (Article (3)b). Investments are limited to the priority sectors specified in Article 1. Proceeds can only be used to establish a new project or to expand the production capacity of an existing company. By implication, debt-equity swaps could not be used simply to finance buyouts or financial restructuring. However, the investor who qualifies under this program would benefit twice: once from the discount on the debt instrument, and a second time in being exempt from all types of taxes. Such a double benefit seems extravagant. Moreover, under the present provisions a host of questions are left unanswered. For a country like Egypt with a heavy debt burden and, at the same time, anxious to promote foreign investment, debt-equity swaps are sufficiently important to warrant treatment in separate legislation.

Finally, some countries, including a number of Arab countries, use the system of free zones to encourage foreign investment. However, the precise function of such a system varies greatly between countries. A distinction should be made between three types.

  • Export processing free zones have existed for a long time in a number of countries—developed as well as developing. The purpose of this arrangement is to provide facilities for carrying out certain processing operations on imported goods without going into the customs formalities to which such goods are subject. Typical of processing operations are packaging, bottling, and labeling. Moreover, they serve as facilities for the transit trade.

  • Export free zones involve more than simple processing. The purpose is to create a zone in which full-fledged manufacturing can be carried out, including the importation of raw materials, technology, and management. Foreign investments are attracted to these zones to take advantage of cheap labor, developed infrastructure, and exemptions from taxes and duties without going into the maze of bureaucratic procedures and regulations that apply to inland projects. Put differently, the purpose is to create an island of economic freedom in an ocean of statism. The underlying assumption is that free zones of this type are effective tools for the development of export-oriented industries.

  • Export-import free zones perform the same functions as the preceding ones but, in addition, they operate as depots for the supply of imported goods to the mainland. Goods enter duty free to the zone but are dutiable when they cross the border into the mainland.

The first type of free zone poses no problem and is advantageous to the host country. The situation is different with respect to the export-import free zones. Experience shows that they soon cease to do much by way of export-oriented industries and concentrate instead on the easier and more lucrative business of supplying the domestic market with imported goods. Because import duties are frequently excessive, the temptation to smuggle highly taxed goods is well-nigh irresistible. The cost in terms of lost public revenue and unfair competition with home industries can be considerable.

As to the intermediate type, the export free zones, it is difficult to generalize, assuming that they are strictly confined to the development of export-oriented industries. On balance, however, the cost could well outweigh the benefit to the host country. The most serious drawback of such arrangements is that they tend to create a dangerous illusion, namely, that the host country can escape the negative consequences of stifling bureaucratic controls through creating isolated islands of economic freedom. They weaken the resolve for economic reform and divert attention from the need to eliminate distortions that damage the overall investment climate.

Restrictions and performance requirements go hand in hand with incentives. Here again the more important the incentives, the greater is the temptation to impose restrictions. The most common restrictions relate to local content requirements, export performance, and trade balancing and ownership requirements. Some of these restrictions have a distorting effect and give rise to misallocation of resources. This is obvious for local content requirements, which operate in much the same way as trade restrictions. But it is also true of export and trade balancing requirements. This consideration explains why some industrial countries insist on their inclusion as trade distorting investment measures in the Uruguay Round of trade negotiations currently under way in Geneva.12

It is also clear that restrictions and performance requirements act for the most part as disincentives to foreign investment. For this reason countries differ greatly on the extent of restrictions they impose on foreign investment. Joint ventures are a case in point. In many countries foreign investors are required to enter into partnership with domestic capital with or without a majority share. The deterring effect of this requirement has led some countries to adopt more liberal provisions. “We can conclude,” says Dale Weigel, “that developing countries are re-examining the role of forced joint ventures between foreign and local investors. The trend is clear—to allow foreign and local firms increasingly to make their own arrangements.”13

Investment guarantees have a different footing. They belong of course to the category of incentives, but they do not affect the taxation system and have a moderate cost to the foreign investor and the host country. Following the emergence of substantial investable surpluses in the oil exporting countries, the Inter-Arab Investment Guarantee Corporation (IAIGC) was established in mid-1975 with the purpose of providing the Arab investor with insurance coverage in the form of reasonable compensation for losses resulting from noncommercial risks as well as carrying out activities that are complementary to the Corporation's main purpose, in particular research related to the identification of investment opportunities and the conditions of investment in the Arab countries.14 Noncommercial risks include nationalization and confiscation, war or political unrest, and inability to transfer earnings or invested capital outside the host country in a convertible currency. As noted by Nour El-Din Farrag, the issue of guarantees for foreign investments made in the industrial countries does not arise as the rights of foreign investors are protected by a strong legal and judiciary system. The goal of the Arab countries should be to reach a stage where the foreign investor does not feel the need for a special arrangement to protect against noncommercial risks—in other words, to dispense with the system of investment guarantees altogether. In the meantime the system currently in force, together with provisions in national legislation as well as the Multilateral Investment Guarantee Agency (MIGA), plays a role in promoting inter-Arab and foreign investment. It bears repeating, however, that “the role played by guarantees in attracting investments is an ancillary or complementary one, and an improved investment climate, in all its various political, economic, and institutional aspects, is really the key factor in attracting direct foreign investments to the Arab world.”15


The views expressed in this paper are the author's and do not necessarily represent those of the seminar.


A. Shakour Shaalan, “The Impact of Macro economic Policies on Investment,” Chap. 2 below. See also comments by Mohamed El-Diri and Fareed Atabani.


Heba Handoussa, “Egypt's Investment Strategy, Policies, and Performance Since the Infitah,” Chap. 7 below. Bachir Hamdouch, “Investment Policies in Morocco,” Chap. 10 below. See also comments by Ahmed El-Ghandour and Abdelrazaq El Mossadeq.


Abdel-Monem Seyed Ali, “Investment Policies in Iraq, 1950–87,” Chap. 9 below. See also the comments by Abdel Wahed Al-Makhzoumi.


See comments by Fareed Atabani.


Abdullah Al-Kuwaiz, “Investment Process in the Gulf Cooperation Council States,” Chap. 8 below. See also the comments by Mahsoun Galal.


John W. Wall, “Efficiency of Public Investment: Lessons from World Bank Experience,” Chap. 3 below. See also comments by Mohamed A. Diab.


For a more detailed analysis, see Privatization and Structual Adjustment in the Arab Countries, ed. by Said El-Naggar (Washington: International Monetary Fund, 1989), p. 12.


Ibrahim F. I. Shihata, “Promotion of Arab and Foreign Investment: General Remarks,” Chap. 6 below.


Handoussa (cited in fn. 3).


Joel Bergsman and Wayne Edisis, “Debt-Equity Swaps and Foreign Direct Investment in Latin America,” IFC Discussion Paper No. 2 (Washington: World Bank, International Finance Corporation, 1988).


Cynthia Day Wallace, Foreign Direct Investment in the 1990's: A New Climate in the Third World (Dordrecht; Boston: Martinus Nijhoff, 1990), especially Chap. 2.


Dale Weigel, “Foreign Direct Investment: The Role of Joint Ventures and Investment Authorities,” Chap. 4 below. See also comments by Abdulaziz M. Al-Dukheil and Ezzedin M. Shamsedin.


Abdel Rahman Taha, “Investment Guarantees: The Role of the Inter-Arab Investment Guarantee Corporation,” Chap. 5 below. See also comments by Nour El-Din Farrag.


Abdel Rahaman Taha (cited in fn. 14).