FDI – Task ahead for policymakers

By H.K. Seneviratne

The highly anticipated new reform process for Foreign Direct Investment (FDI) would initially take off from April this year with the implementation of the Budget proposals for 2011/2012 with legislative changes to the country’s tax structure.

This new reform process is backed by an ambitious goal to draw FDI up to US$ 1 billion in selected areas in agriculture, fisheries, business outsourcing, education, shipping, aviation, infrastructure and tourism.

The new policies are also expected to rationalise tax concessions, which were given to attract foreigners due to the prolonged war and these seem not relevant in the post war. The expectation of the government is both to attract FDI to increase investments and also to ensure the future tax base of the country is protected.

The Government will be looking forward to a different regime of incentives that take into account the special needs of the country which would be available for investors across the world in all the selected sectors and is also planning to expedite the FDI approval process to minimise bureaucratic delays.

FDI goals

As against the above ambitious goal, it is not out of point to mention that in 2008, in the wake of civil war, the inflow of FDI hit a record US$ 889 million, but fell in 2009 to US$ 602 million due to the global financial downturn. The FDI performance up to September 2010 was US$ 310 million which was a 16.8 per cent drop compared to US$ 350 million in the same period in 2009.

Yet, the Government, with the new reforms in mind, is ambitiously aiming for US$ 1 billion in 2011, 1.5 billion in 2012 and US$ 2 billion in 2013. Even with these ambitious targets, Sri Lanka’s global capital flow remains small compared to flows to and among industrialised and major emerging economies.

In considering the much-poorer-than-expected performance in absorbing FDI, despite the restoration of normalcy in the country since May 2009, it shows that war is not the only problem for not picking up FDI as originally expected.

The drop in FDI inflows despite the expectation of the Government in the post war strongly suggests the need of this crucial juncture is an effective response of the Government to make the policy environment more favourable to foreign investments.

Uncertainties still prevail and foreign investors are not certain about the macro economy of the country in the long run. The issues are raised that some of the Governmental policy instruments are against foreign investments, blaming the open economic policies. The Government’s policy document, the blueprint of the vision for the future, released before the President’s election to the second term, has stated that 1977 reforms opened the way to foreign investment that undermined local investments.

Undoubtedly, though FDI is to be considered a major source of financing for developing countries, it in itself is no panacea as FDI can sometimes compound problems during times of financial crisis. It is vulnerable and foreign investors can shift financial resources from one country to another, adding macroeconomic instability to developing countries. This trend is more susceptible in foreign portfolio investment.

Vital source

The global spectrum is clear that over the past decades the FDI has become a vital source of economic development of the developing countries. We have witnessed FDIs’ growing importance as the primary source of financial capital flows into the economies to complement the conventional dependence on bilateral and multilateral aid in the form of Overseas Development Assistance (ODA). The FDI inflows generally provide a more stable source of external financing than private debt and portfolio equity flows.

The advantage of FDI is that rather than debt creating capital flows, it brings not only increased access to foreign exchange, trade and employment, but also new products, information and technology. Virtually, in the circumstances, all economies, large or small, are now competing with each other to attract FDI.

It is inevitable that the Government should come up with a strong commitment to develop a set of policies conducive for FDI to enable maximising returns on investment and contribute fully to the economic and social progress that the Government needs.

The policy instruments should not only be focused on investment promotion, but also address issues such as human capital, infrastructure and enterprise development and increase FDI spill-over effects, fostering close linkages with local suppliers and economic diversification.

Inequality in distribution

In the global scenarios it will be seen that level the inflow of FDI has not been equally distributed among the developing counties and developing regions creating a large cross-regional inequality in the growth of FDI. One reason behind cross-regional disparities of FDI may be due to concentration of FDI in selected countries. The regions surrounded by large markets tend to attract more FDI.

The inequality in attracting FDI among nations within regions or otherwise does not necessarily diminish the role of the small countries in the quest for more FDI. If FDI is measured as a fraction of GDP, many small countries actually fare better than most of the large host developing countries. The small economies are now making their modest attempts to increase their market share by bilateral and regional market integration.

Inflow of FDI

The inflow of FDI will generally be in two forms: Mergers and Acquisitions (M&A) and Greenfield investment. The former include equity acquisition of indigenous private companies and privatisation of indigenous public enterprises. Greenfield investments on the other hand involve an inflow of new capital in setting up of an entirely new facility which has not existed previously. Of the two investment alternatives, Greenfield investment is more likely to have a strong impact on a host country.

Since Sri Lanka is a Small and Vulnerable Economy (SVE), its country profile needs thorough reconsideration of established conceptual frameworks and needs to encourage the development of specialised policy making tools in taking into account recent shifts in the global pattern in capital inflows and outflows.

Doha Declaration

The Doha Declaration adopted by the World Trade Organization (WTO) recognises that a developing country which is constrained by its smallness, vulnerability or remoteness would receive a treatment designed to overcome the specific effects associated with those constraints and this treatment would be in addition to the Special and Differential Treatment (S&DT) in addressing their problems of market access.

The Doha text, however, does not specify which countries would be the beneficiaries of this special treatment and WTO in fact had not intended to create a sub-category among the developing WTO member countries. What was significant is the recognition for flexibility in the formulation of internal policy tools by SVEs in the context of the global multilateralised rule-based system.

At this crucial juncture, the scenario is now clear that the small and vulnerable economies in presenting their policy objectives are faced with new frontiers in strategic repositioning tailored to the uniqueness of the countries.

Whether the smallness is a liability or an asset in attracting inward FDI rests upon the effective policy measures formulated by the governments to support a more sustainable form of development in the long run.

Crucial question

A crucial question is to assess the relative advantage of FDI to support more sustainable form of development, particularly in those countries with burgeoning debts and widening income disparity to the rest of the world.

The impact of tariff concessions and transfer pricing can reduce the level of corporate tax received by the capital recipient host countries. Also, importation of intermediate goods, management fees, royalties, profit repatriation, capital flight and interest repayments on loans can limit the economic gain to host economy.

Driven by the complexity in the strategies in the adoption of policy tools to stimulate one’s national economy, to attract FDI varies depending on particular circumstances in each and every country, taking into consideration the ramification of a variety of factors that the capital exporting countries look for in deciding to do their business different from their own.

The traditional location specific determinants for a competitive environment for FDI over the others includes, among other things, the size, income level, urbanisation, stability, both economic and political, growth prospects, access to regional markets, treatment towards the private sector, ease of entry and exit of M&Es and Greenfield investments, ease of remittances, access to foreign exchange, local labour, resources legal framework and good governance.

Although FDI inflow is strongly driven by the traditional determinants it is not determined solely by domestic determinants and in some instances access to regional markets supersedes the access to national market. This depends on how well the country is integrated into regional blocks. In the one must be mindful of crisscross effect of bilateral, regional and multilateral commitments made by the country.

Policy reforms

The extent to which a developing small economy like Sri Lanka could adopt protectionist policies for a sustainable economic development would also depend on the internal and external factors that militate against it.

Given the complexities attended in the formulation of policy tools to attract FDI to stimulate the national economy for a sustainable economic development, it is the legitimate expectation of the business community and the public at large that the Government would come out strongly with the much-proclaimed policy reforms for which the Government not only had sufficient time to do so and it cannot spare with ad hoc changes for the sake of changing against the wealth of past experiences in the FDI scenarios.

(The writer is a LL.B graduate of Colombo University and an Attorney-at- Law. He was one-time Head of Legal of BOI and Legal Consultant and Secretary to the BOI Board.)