Determining FDI Potential: Are National Policies and Incentives Sufficient?

Foreign direct investment (FDI) is increasingly becoming a preferred form of cap ital flows to developing countries in recent years, as compared to other forms o f capital flows. The reasons for this are not hard to seek. In the context of th e gloom and despair of the heavy debt burden plaguing these countries, FDI promi ses to be the bright ray of hope for harnessing capital flows to the countrys eco nomic development without the pangs of capital repayment with interest. In this context Feldstein and Razin (2000) and Sodka (forthcoming) note that the gains t o host countries can take several other forms: FDI allows transfer of capital and technology, which is not possible through fin ancial investment in goods and services. FDI also promotes competition in the domestic input market Profits generated by FDI contribute to the corporate revenue in the host country Operation of new ventures by FDI leads to employee learning in the host country who learn how to manage and operate the businesses. This contributes to human ca pital development of the host country. Profits generated by FDI contribute to tax revenues in the host country FDI is different from other major types of external private capital flows in tha t it is motivated largely by the investors long-term prospects for making profits in production activities that they directly control. Foreign bank lending and portfolio investment, in contrast, are not invested in activities controlled by banks or portfolio investors, and are often motivated by short-term profit cons iderations that can be influenced by a variety of factorsfor example, interest ra tesand are prone to sudden reversals (capital outflows) if any/some of these fact ors turn unfavourable. Mallampally and Sauvant (1999) claim that the importance of FDI also lies in the fact that it not only a means of transferring technolog y and skills and managerial practices, but also of accessing international marke ting networks. The greater the supply and distribution links between foreign aff iliates and domestic firms, and the stronger the capabilities of domestic firms to learn from the presence and competition from foreign firms, the more likely it is that the qualities/attributes of FDI that enhance productivity and compet ition will spread. Recent evidence A comprehensive study by Bosworth and Collins (1999) on the effects of capital i nflows on domestic investment for 58 developing countries during 1978-1995 cover ing nearly all of Asia and Latin America as well as most of Africa finds that an increase of one dollar in capital flows is associated with about 50 cents incre ase in domestic investment, while the ratio is about one-forone between FDI and domestic investment. There is virtually little or no impact or relationship bet ween portfolio inflows and investment. FDI has also proved to be resilient during financial crises. Loungani and Razin (2001) point out that such investment was remarkably stable in East Asian countr ies during the global financial crises of 1997-98 in contrast to portfolio equit y and debt flows, which were subject to large reversals during the same period. UNCTAD, in its recent World Investment Report, asserts that FDI has the potentia l to generate employment, raise productivity, transfer foreign skills and techno logy, enhance exports and contribute to the long-term economic development of th e worlds developing countries. According to a recent UNCTAD report: on World Inve stment: Foreign affiliates of some 64,000 transnational corporations (TNCs) generate 53 million jobs. FDI is the largest source of external finance for developing countries. Developing countries inward stock of FDI in 2000 amounted to about one-third of t

heir GDP , compared to just 10 percent 10 percent in 1980. One-third of global trade is intra-firm trade. Similarly, Mallampally and Sauvant (1999) also assert that the increase in direc t investment flows has laid the foundation for a marked expansion of internation al production by TNCs, which now have an estimated $3.4 trillion invested in abo ut 449,000 foreign affiliates. The value of sales by these foreign affiliates ha s increased more rapidly than that of foreign trade (world exports). National Policies and Incentives for FDI in Bangaldesh The second half of the 1990s witnessed a surge of FDI inflows in Bangladesh, wit h the major sectors attracting FDI being oil, gas and power, followed by chemica l industries and cotton and textile industries. USA, Malaysia and UK dominate th e FDI scenario in Bangladesh. However, the inflow of FDI compared to neighbourin g developing countries is below expectations. To understand why this is so, it i s necessary to look into the national policies and incentives for FDI in Banglad esh. Like other developing countries, Bangladesh has also adopted a number of policie s and provided generous incentives to attract foreign direct investment (FDI) in to the country In According to experts, Bangladesh seems to offer perhaps the mo st liberal FDI regime in South Asia. These, among others, include: tax holiday for 5 to 7 years, income tax exemption for 15 years for the experts of foreign enterprises, protection from double taxation, exemption from duty for importing machinery and spare parts for 100 per cent export-oriented units, full repatri ation of profit and dividend by the foreign companies, eligibility for full work ing capital loans from the local banks on banker-client relationship, option for foreign firms or joint ventures not to sell their shares through public issues, and protection from expropriation by the state under Foreign Investment Promoti on and Protection Act of 1980. Bangladesh is also a signatory of the Multilatera l Investment Guarantee Agency insuring investors against political risk. As a me mber of World Intellectual Property Organisation (WIPO) and World Association of Investment Promotion Agencies (WAIPA) the country further safeguards the intere st of foreign investment. Standard dispute settlement procedures are followed in case there is any dispute with the government or with any private party. If the foreign investors feel that their rights have been violated, they can file writ s with the High Courts. However, recent trends in global FDI flows lead one to conclude that national po licy guidelines and incentives are not the main determinants of FDI. Despite the best tax reliefs and other incentives compared to neighbouring countries, a cou ntries FDI potential may still be low, or it may be an under-performer. To unders tand these issues, let us look into the economic determinants of FDI, the reason s for investment from the investors point of view, as well as what determines th e FDI potential of a country. Economic Determinants of FDI From an economic perspective, determinants of FDI can be grouped into resource-o riented and market-oriented determinants. The resource-oriented determinants inc lude availability of raw materials, low-cost skilled/unskilled labour, technolog y-created or innovation-created assets and physical infrastructure. Market-orien ted determinants for FDI inflows from the host countrys perspective generally ref er to the market size and marketability of the field products for which FDI is s ought. Projects that depend on a resource (e.g. oil and gas and mineral processi ng projects) often have to compete for capital funds with similar projects propo sed elsewhere to investors. Proponents of non-resource-based projects seek the l owest cost/highest return location for their investments. Other economic factors such as liberal industrial policy reforms, liberalization of policies related to FDI, investment treaties with other countries for promot ion and protection of investment, incentive packages, etc. come after considerat ion of the factors mentioned earlier.

FDI Story From The Other Side: Why Foreign Firms Look Abroad [change and shorten] There are various theories explaining the behaviour of multinational corporation s (MNCs) in investing abroad. A summary of some of those theories may be forwar ded to explain the behaviour of MNCs. [shorten these theories] A transactional theory of MNE (Multinational Enterprises) has been forwa rded by Caves (1981). According to him, MNEswhich are essentially multi-plant fir mscan be grouped into three broad categories: 1. Horizontal multi-plant firms 2. Vertical multi-plant firms 3. Diversified MNEs Horizontal Integrationthe Intangible Asset Theory It has been empirically observed that plants in different countries under common control of an MNE tend to have greater profitability through lower costs than i f they operate under different managements. An explanation for this behaviour is found in some peculiar characteristic which an MNE possessessome intangible assetun ique to the firm. Such intangible asset may be in the form of a special skilltech nology, know-howor it may be in the form of a trade mark, or special skill in mar keting a product. When an outside firm operates in a country, it is put up with costs not faced by the local firm, such as familiarity with the environment (inc luding language, culture, etc.), sources of raw materials, the local firms way of doing things, etc. Therefore, the successful foreign firm must have certain tra nsactional advantages which offset the costs and place it over local competitors . Vertical Integration An MNE can exist in vertical integration as well. Suppose a processing firm need s information about future prices and available raw materials for its production plans. The producers of that raw material may withhold that information. In suc h a case, the processing firm stands to gain by vertical integration. The presence of multinationals in the services sector such as banking or advert ising is also explained by the transactional theory. Due to long-term relationsh ip with its client or some other special facilities it provides, a bank may grow a special relationship with its customers in a country, which lowers the costs of transactions. It can use these techniques in other countries to derive similar advantages. Thus it goes multinational. Diversified MNE Multinational firms can be divided into a third categorythe diversified MNE. A ccording to Caves, since foreign investment is a risky activity, an MNE could dive rsify its risks by investing across countries. Economic conditions are generally uncorrelated across countries. Therefore, adverse economic conditions, governme nts policy changes, etc. could have a downward effect on investments in a country , but if investments were spread among countries, such losses could be wholly or partially offset by gains in another country. Diversification among products also tends to reduce risks in a similar manner. I nvestment in LDCs offers a strong case for an MNE to diversify its interest amon g different products in view of the restriction posed by many LDCs on repatriati on of profits, royalties, etc. Once a company has decided to look abroad, the next step begins: investigation. The company sends a team to investigate the setting abroad. A partial listing from the Foreign Investments Checklist for US business abroad includes the following: FOREIGN INVESTMENT CHECKLIST: Some Factors For Consideration By US Business In Exploring Investment Abroad

1) The general political atmosphere 2) Attitude of the foreign government towards foreign investment 3) Administrative practices affecting the prospects in investment, such as import quotas, tariffs, availability of patent/trade-mark., etc. 4) Existence of investment guarantee agreement with US 5) Government assurances regarding remittance of profits and repatriation o f capital 6) Tax rates which effect the proposed enterprise 7) Trade agreements with other countries 8) Availability of auxiliary industries 9) Extent and elements of competition 10) Extent of market 11) Availability of domestic raw materials and spare parts These are the issues on which a company tries to make information available. But a little reflection will reveal that to gather all the information is an extrem ely difficult time consuming and costly affair. So it may not be practical. The company is thus faced with a limitation which forces it to adopt these methods. First, preliminary investigation starts at the companys office, on the basis of r eadily available information, and executives are directed to go into the country only if the company qualifies in the first three criteria tests. Second, the hi gh cost of obtaining information poses a barrier to investment in the LDCs, so t he willingness of a company to invest will be higher the more easily and readily information is available. Thirdly, since a lot of information will not be cover ed, the firm will stress on flexibility as a guard against uncertainty. Rigid te rms offered by a host country will refrain the firm from investing there. At the end of investigation, it is logical to assume that the next step would be to take the decision whether or not to invest. But this is not always s o. According to Aaron (__) decisions to invest are sometimes taken a priori, on the grounds such as commitment to hold the market or to protect the initial inve stment, and investigation seeks how to implement the decision. UNCTADS FDI Performance Index The United Nations Conference on Trade and Development (UNCTAD). conducted anal ysis to provide truer measures of the performance of the countries in attracting FDI. First, they created the FDI Performance Index by calculating the ratio bet ween each countries share in global FDI to its share of global GDP. Second, the y constructed the FDI Potential Index, using a set of structural variables to as sess the potential for countries to attract FDI. These two indices were then used to split countries into one of four categories: front-runner - high FDI potential and performance, consisting of developed count ries utilising their potential; above-potential - low FDI potential but high FDI performance; below-potential - high FDI potential but low FDI performance; and under-performer - low FDI potential and performance, consisting of developing co untries limited by poverty or instability. The second and third categories are most interesting, as countries in the first and fourth categories are performing to expectations. The second category is dra wing more than their potential warrants, while the latter group has shortcomings that are preventing their structural FDI from being realised. Table 6 INWARD INVESTMENT PERFORMANCE AND POTENTIAL (1999 - 2001) High FDI Performance Low FDI Performance High FDI Potential Front-runners Includes: Canada, Germany, United Kingdom, Malaysia, New Zealand Below-potential Includes: Australia, United States, China, Qatar, Japan,

Low FDI Potential Above-potential Includes: Albania, Brazil, Honduras, Papua New Guinea, Vietnam Under-performers Includes: Bangladesh, India, Iran, Nepal, Sri Lanka, Turkey Data source: UNCTAD Regarding Bangladesh, the UNCTAD mentions that Bangladesh has reached the 122nd position from 133rd in the World Investment Report (WIR) index of the UNCTAD. A ccording to the report, Foreign Direct Investment (FDI) rose by 72 per cent in 2 004 over the previous years figure. Factors Determining The Inward FDI Potential Index The Inward FDI Potential Index captures several factors (apart from market size) expected to affect an economys attractiveness to foreign investors. It is an ave rage of the values (normalized to yield a score between zero, for the lowest sco ring country, to one, for the highest) of 12 variables (no weights are attached in the absence of a priori reasons to select particular weights): GDP per capita, an indicator of the sophistication and breadth of local demand ( and of several other factors), with the expectation that higher income economies attract relatively more FDI geared to innovative and differentiated products an d services. The rate of GDP growth over the previous 10 years, a proxy for expected economic growth. The share of exports in GDP, to capture openness and competitiveness. As an indicator of modern information and communication infrastructure, the aver age number of telephone lines per 1,000 inhabitants and mobile telephones per 1, 000 inhabitants. Commercial energy use per capita, for the availability of traditional infrastruc ture. The share of R&D spending in GDP, to capture local technological capabilities. The share of tertiary students in the population, indicating the availability of high-level skills. Country risk, a composite indicator capturing some macroeconomic and other facto rs that affect the risk perception of investors. The variable is measured in suc h a way that high values indicate less risk. The world market share in exports of natural resources, to proxy for the availab ility of resources for extractive FDI. The world market share of imports of parts and components for automobiles and el ectronic products, to capture participation in the leading TNC integrated produc tion systems (WIR02). The world market share of exports of services, to seize the importance of FDI in the services sector that accounts for some two thirds of world FDI. The share of world FDI inward stock, a broad indicator of the attractiveness and absorptive capacity for FDI, and the investment climate. A formula for determining investment potential in Asia [Modify write-up language] A formula for determining investment potential in Asia is proposed by Lawrence Yeo, founder, CEO and principal consultant of AsiaBiz Strategy. He explains the best way for companies to gain market entry in Asia by using a formula that iden tifies opportunities, explores resources and analyses core competences before ma king a move. Many of our repeat Fortune 500 and global clients have regularly sought our Asia market entry and marketing strategy advice, because Asia is so heterogeneous an d diverse. They ask: Is Asian Country 1s industry X attractive? How about Asian Country 2s ind

ustry Y? Such randomised market selection and industry targeting is inadvisable. To share with our corporate readers how we advise clients to enter Asia, here is a sneak peak inside the mind of an aspiring world-leading Asian consultancy. We can identify and assess Asian opportunities using a simple framework that can be easily yet simultaneously performed across many Asian countries at once. First, we review the clients Asia strategic intent and mission. Next we analyse t he external environments of Asian countries (legal and regulatory environment, c ompetitive environment, business environment, and so on) and the internal enviro nment of the client (key success factors, value/distribution analysis, marketing or branding audit, Asia strategy review, and so on). And finally we formulate t he appropriate Asia strategy. Three-part formula The strategy formula has three parts: A, B and C: A is identify and assess Asia opportunities; B is explore resources and capabilities to determine the best strategies; and C is analyse core competences to determine modes of entry into the Asian market. This is followed by strategy implementation. To help assess the attractiveness of various Asian markets and industries, we fu rther modify the GE-McKinsey Portfolio Analysis. Market attractiveness Market attractiveness has replaced market growth as the main factor of industry attractiveness. In turn, many factors can affect market attractiveness, such as market size, market share, market profitability, pricing trends, competitiveness intensity, entry barriers, market segmentation, and so on. Lets take Singapore for example. We can use a rating scale from 1 to 5 where 1 me ans very unattractive and 5 means very attractive. The model takes into account ratings for: GDP output Market growth rate over the past five years: growth is the most important assess ment factor and it takes precedence over size and other factors when considering industry attractiveness. It is based on the historic growth of each industry fo r the past five years. Concentration of companies within the same industry: high competitive intensity translates to lesser profit shared among players, hence lowering attractiveness of the industry. Product sales nature: this is defined as the dependency of sales of products/ser vices in the specific industry on the changes in the business environment. Government support: the Singapore government plays an active role in supporting Singapores business; therefore government support is a crucial factor for evaluat ing industry attractiveness. Here, our analysis shows that Singapores industries, in order of descending attra ction, are: High attractiveness: wholesale and retail; transport, logistics and communicatio n; business/ commercial/professional; IT and e-commerce; and other services. Mid attractiveness: food, beverages and tobacco; electronic products and compone nts; other manufacturing sectors and financial services. Low attractiveness: wearing apparel; footwear and leather; publishing and printi ng; construction and engineering; and hotels and restaurants. Market conditions Also, we look at our clients market strength. For small and medium-sized enterpri se clients, we will look at Asian market conditions and likely Asian competitors countermoves and recommend using a niching strategy, substitution strategy, free-r iding strategy and strategic alliance strategy or some combination of these. The Asian Development Bank also points out that foreign firms are attracted to c ommercially profitable and politically stable environments, and that offering in centives is often less effective at attracting investment. A recent issue of The

Asian Development Outlook, states that FDI in developing Asia grew from $694 m illion in 1970 to $ 138.6 billion in 2000, before declining to $ 90.1 billion in 2002, representing a growth of 15.2 percent per year. In order to attract the h uge amount of foreign direct investment pouring into the region, economies shoul d move away from restrictive investment regimes and alow wholly owned subsidiari es to operate.

FDI situation Bangladesh According to an UNCTAD report, FDI to Bangladesh averaged $7 million annually fr om 1990-1996, but increased to an annual average of $196.8 million from 1997-200 0, primarily due to foreign investment in Bangladeshs energy sector. In 2001, how ever, new FDI dropped 72% (to $78 million) from the previous year. In 2002 new F DI again dropped to $52 milli0on. But in 2003 the FDI jumped to $120 million. Bangladesh has, very often sent trsde delegations abroad to explore trsde opport unities as wel as highlightopportunities for investing in Bangladesh. A number o f foreign business delegations have visited Bangladesh to explore trade and inve stment opportunities, including from India, France, Turkey, Malaysia, Taiwan Chi na, and Korea. What is the story from the other side? How do foreigners see inveetment prospect s I Bandladesh? A survey of recent reports on the issue including a recent Inves tment Climate Statement on Bangaldesh by the Bureau of Economic and Business Aff airs of the US Government found the following: foreigners often find that minist ries request unnecessary licenses and permissions. Added to these difficulties a re such problems as corruption, labour militancy, poor infrastructure, inadequat e commercial laws and courts, inconsistent respect for contract sanctity, and po licy instabilityfor exampledecisions taken by previous governments being overturne d when a new government comes to power). To a lesser extent, difficulty in attra cting foreign investment also results from Bangladesh s image as an impoverished and undeveloped country subject to frequent and devastating natural disasters. Imperatives for Bangladesh Despite the overall poor investment environment, Bangladesh achieved notable suc cess in some fields during the past years. By the end of the last decade, growt h rate of GDP exceeded 5 percent, whereas population growth rate declined to 1.5 percent. Hence per capita income was increasing at a rate of more than 3 perce nt a year. The situation is much better than what it had been in the 1980s when GDP growth rate hardly exceeded the population growth rate. Investment has incr eased to 22-23 percent of GDP. Private investment marked a faster growth than pu blic investment. Dependence on foreign aid declined significantly. Sectoral comp osition of the economy also marked some positive changes. Share of agriculture now declined to around 25 percent, while share of service and industry has incre ased to 50 percent and 25 percent respectively. Inflation rate is very low. Ove rall macroeconomic balance had been sustainable in the last decade, until the FY 2002. 3.2. Success of Bangladesh is quite remarkable in select social and economic sectors. Bangladeshs literacy rate has increased to more than 60 percent during the past decade. Textile and some other manufacturing sectors registered modest success. Some of Bangladeshs textile sector units are using state of the art te chnology and are capable of competing in the global market. Likewise, pharmaceut icals and cement industries have experienced significant quality and capacity ex pansion. The countrys industrial and To be competitive in international markets, and to upgrade its potential in the foreign investors eyes, Bangladesh needs to adopt urgent plans for the short-run and the medium term. Here a distinction has to be made regarding factors and situations which are out side the direct control of the government and those over which it can exercise d

irect control and initiative. While indices such as increase in the GDP per capi ta, share of exports in GDP and increasing the share of FDI in the services sect or are not under direct control of the government, and can only be influenced in directly by it, the government should take immediate initiatives to develop thos e sectors directly under its control. such as developing the infrastructure, spe cifically port infrastructure and ICT Developing infrastructure Developing the infrastructure particularly Chittagong port is an utmost priority for developing FDI potential in Bangladesh. {Mention example of SINGAPORE] Chit tagong port is commercially important to Bangladesh as it handles nearly 85 perc ent of the countrys exports and imports. Besides, Bangladesh is located at the ce ntre of the South Asia Regional Economic Co-operation (SASEC) countries, having borders with India and Mynmar and with close proximity with land-locked countrie sNepal and Bhutan. However, problems like outdated machinery, inadequate storage space, time-consuming custom procedures, and hartals make it one of the costlies t ports in Asia. The port is heavily congested and ship turnaround time needs 4 to 5 days compared to 1 to 2 days in Singapore and Bangkok. Besides, the number of export containers has not increased at a pace matching the rate of increase i n the number of feeder vessels. Container handling costs around $600 as against $150 to $300 in neighbouring ports.It may be mentioned here that as a measure t o make the port more efficient, the Government initiated measures such as import of gantry cranes. Four gantry cranes were commissioned at the port on January 3 0, 2006 to make cargo handling more efficient. But due to inefficient manageme nt, notably, absence of skilled operators and modern vessels, they are being use d up to only a third of their capacity According to port officials, although each of the cranes has a capacity of handling 30 TEUs (Twenty Equivalent Units) of containers per hour, they can hardly handle more than 10 TEUs per hour. Port users have recommended privatization as well as corporatization of maritime por ts of Bangladesh, including Chittagong Port, to bring them in the capital market and thus make them efficient for handling growing volumes of cargo. In keeping with thesituation, the Bangladesh Government has decided to allow private sector participation in the port sector. Additionally, for expediting port services, the Government may opt for leasing of equipment for port handling and leasing o f floating crafts from the private sector. Similarly, Bangladesh Railway too is incapable of carrying and delivering the co ntainer cargoes efficiently and timely due to poor capacity, and lack of operati onal efficiency. Despite huge demand, Bangladesh Railway currently accounts for less than 15 percent of container trans-shipment in the Dhaka-Chittagong Econom ic Corridor (DCEC), which provides potential sub-regional linkages to northeaste rn states of India as well as Nepal and Bhutan. Regarding road infrastructure, although there has been a rapid expansion of road network, there is hardly any significant trans-shipment through road transport because it cannot handle container lorries due to capacity constraint. So far as Information and Communication Technology (ICT) is concerned, the count ry is at an emerging stage and lacks behind other Asian countries in comparison. However, a mentionable initiave is that the Ministry of Science and Information & Communication Technology, in cooperation with the public/private sector, has tak en program to produce quality professionals and skilled manpower in ICT. Nationa l ICT Task Force decided to introduce ICT Internship Award Programme in the country. Under this program, gra duates/ fresh graduates/post graduates in ICT subjects will be imparted training for 6-m onths as internees in different IT organizations/companies for acquiring practical experi ence and hands on training. The objective of the program is to impart basic training for skill

development. Conclusion From the above it may be concluded that to attract FDI in a meaningfully large w ay , it is important for Bangladesh to look beyond offering lucrative incentive packages and also inculcate the criterion leading to increasing its FDI potentia l within a short time.