Information about Europe Europa
Journal Issue

Facilitating Foreign Investment

International Monetary Fund. External Relations Dept.
Published Date:
January 1992
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Some dos and don‘ts

Attitudes toward foreign direct the 1970s, many developing country governments discouraged such investment on the grounds that foreign firms would reap “rents” (i.e., unearned profits) at the expense of the local economy. At the same time, the abundant supply of commercial bank credit crowded out FDI inflows. But then along came the debt crisis, drying up the flow of bank credit to developing countries.

As a result, during the 1980s, many countries were forced to ease their restrictions on FDI and change their policies to attract FDI. Over and above the lack of alternative financing, governments realized increasingly that FDI can bring benefits that are vital in an age of increasing international competition and that cannot be obtained in any other way: technology, new management methods, access to export markets, and generally a way of becoming better “plugged into” the global market place. Today, far from deterring investment, developing countries, as well as the emerging market economies of Eastern and Central Europe, are competing with each investment (FDI) have changed considerably over the last two decades. During other to encourage foreign investors.

The Bank Group’s Foreign Investment Advisory Service (FIAS) has been operating for five years, providing advice to over 40 governments, including those of formerly centrally planned economies, on how to improve the climate for productive FDI. Its advice is tailor-made to the particular needs and circumstances of each country. Nevertheless, out of the body of FIAS recommendations, several common threads have emerged over the years.

Listed below are some of the most important “dos” and “don’ts.” But a caveat is in order: No single change in policy along the lines of any or all of the following recommendations will ensure a substantial FDI inflow unless corporations consider the overall business climate to be satisfactory and can expect government policies to be reasonably stable. Acceptable guarantees of private property rights are of course fundamental.

Word of mouth and the attitudes of established investors are the most potent promoter/deterrent of foreign investment. Indeed, research has shown that “agglomeration effects” (i.e., the existence of already-established foreign and domestic firms and of the necessary infrastructure) are one of the most powerful stimulants for other firms to invest in a foreign country. Still, any serious attempt to improve the business climate is likely to include many of the following FIAS recommendations. This advice has not only proven to be of key importance in Eastern Europe but is also highly relevant to developing countries, such as India, which are now trying to attract larger flows of FDI.

Screening investment proposals

Do permit unrestricted entry of foreign investment in general, limiting the number of investments that must be screened for approval to a short “negative list” This is more efficient than screening all investment proposals one by one under a “positive list” of acceptable pursuits. The negative list might include, for example, industries related to national defense or highly protected industries. It is best to keep the negative list short and to avoid using vague or open-ended criteria, such as “activities of strategic importance” or “small businesses.” All investment in nonlisted activities should be allowed to proceed without examination or need for approval. Such projects are, of course, subject to the laws of the land, which apply to all investments, domestic and foreign, such as laws relating to registration, safety, labor, environment, and taxes.

Investment incentives

Do define clearly the types of investment activities that will garner incentives and then grant these incentives automatically, minimizing discretion or negotiation. In an ideal investment climate, there would be no need for incentives. Most developing countries, however, fall short of this perfect situation and need temporary incentives to encourage investment. The incentive should be linked directly to the type of activity that is to be encouraged, for example, exporting or employing labor and not just for the mere act of investing. Incentives are far less attractive to investors if they must bargain in order to get them. Bargaining over incentives wastes time, adds uncertainty, and invites corruption.

Don’t favor foreign investors over local ones in granting incentives. Many developing countries are granting excessive incentives to foreign investors. Offering superior benefits to attract international capital is not only unfair to national entrepreneurs but will also encourage questionable joint ventures, in which foreign partners will be sought merely to qualify for incentives. Ideally, government policy should be non-dis-criminatory to domestic and foreign firms alike, in line with the principle of national treatment.

Don’t use tax holidays. Experience shows that total elimination of taxes is not necessary to attract serious corporations. Such companies expect a reasonable level of taxes. In fact, they strongly prefer a steady, reasonable tax rate that enables them to make long-term financial plans, rather than a tax holiday followed by high, uncertain rates. Moreover, eliminating tax holidays will boost government revenues.

Transfer of dividends and remittances

Do permit unrestricted transfers abroad of dividends, capital, royalties, fees, and repayment of international loans. Investors bring their capital to emerging markets to earn a profit, and they must be assured that they will be able to take their earnings home. It is fair for governments to tax these earnings at reasonable rates. But governments should not interfere with foreign investors when they move their own funds out of the country. The only formality should be to fulfill reporting requirements, so that governments can keep track of capital flows.

Foreign Investment Advisory Service

In response to a strong interest among governments for attracting foreign direct investment, the International Finance Corporation created FIAS in 1986. Two years later, the Multilateral Investment Guarantee Agency (MIGA) was added as a joint venture partner in sponsoring FIAS.

Today, FIAS works around the world, advising governments in over 40 countries on how to obtain increased flows of foreign direct investment. FIAS offers help in building an attractive investment climate by counseling governments on laws, policies, regulations, and procedures. It also assists in creating an effective institutional framework for governments to interact with investors, including developing investment promotion strategies. FIAS helps governments to meet their long-term development needs by maximizing the advantages of foreign investment for transferring capital, technology, and managerial expertise. With today’s attention focused on accelerating economic growth through a dynamic private sector, FIAS is a key player in the World Bank Group’s efforts.

Don’t place restrictions on foreign investors’ access to foreign exchange. Governments should be willing to convert currency at the prevailing rate. Limiting access to foreign exchange will deter foreign investors, particularly those who intend to sell products locally, which may be in short supply.

Governments may worry about the balance of payments effects of allowing the free transfer of dividends and other remittances. So long as few foreign firms have invested in a country, and new firms are coming in little by little, foreign exchange outflows are unlikely to be substantial. Indeed, it may take years for a newly established firm to make profits, and so long as the business climate is good, much of the profits are likely to be re-invested rather than remitted. If in later years foreign investment should play a more prominent role, that would normally be part and parcel of a dynamic economy, which experiences net inflows for years. The balance of payments drain of capital and dividend remittances will usually be balanced by additional exports and efficient import substitutions when the investments are made in undistorted markets. Only much later do sustained net outflows occur (for instance, in Taiwan Province of China, Hong Kong, and Singapore), and that is a sign of success. Meanwhile, should a temporary balance of payments deficit occur, governments can always impose emergency restrictions on foreign currency outflows.

Investment promotion

Don’t undertake expensive investment promotion efforts, such as sending missions abroad or advertising internationally, until the investment climate at home is satisfactory. It is not productive to try to lure investors to visit a country where there are still serious shortcomings or un-certainties in the business environment. Before international efforts are made to attract new investors, a promotion agency should first establish a “service function” at home to help foreign investors who come to the country on their own initiative.

Do establish an investment promotion agency with close tiesto the local private sector and a focus on investor support rather than on screening. A quasi-governmental body with a mixed public/private board of directors may be the best arrangement. This would be superior to a purely public agency, which investors might distrust. A quasi-governmental agency can also have advantages of administrative freedom, such as the ability to offer competitive salaries to attract top-quality employees. At the same time, strong links of promotion agencies to the government are essential. Promotion agencies should help investors in very practical ways, for example, by steering them through the different bureaucracies with which they must deal. The promotion agency should also keep investors up-to-date on changes in laws and business regulations.

Guy Pfeffermann

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