NOTE NUMBER 327 67803 viewpoint PUBLIC POLICY FOR THE PRIVATE SECTOR FINANCIAL AND PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY AUGUST 2011 Attracting FDI Kusi Hornberger, How Much Does Investment Climate Matter? Joseph Battat, and Peter Kusek Business opportunities—as reflected in the size and growth potential of Kusi Hornberger markets—are the most powerful drivers of foreign direct investment. (khornberger@ifc.org) is But investment climate features such as strong institutions and investor- an economist, and Peter friendly regulations also matter and may even boost the development Kusek (pkusek@ifc.org) a senior investment policy impact of the investment. Moreover, many elements of the investment officer, with the World climate can be reformed in the short run and at comparatively low Bank Group’s Investment Climate cost. Improving the investment climate therefore offers an excellent Department. Joseph opportunity for countries seeking to attract foreign direct investment. Battat (jbattat@ifc.org) is a retired former manager There are promising trends in global foreign head toward US$2.0 trillion in 2012 (UNCTAD of the department with direct investment (FDI) flows for developing 2011b). And senior executives of multinational more than 30 years of ex- and transition economies. Each year more and corporations are becoming more optimistic about perience advising govern- ments and multinational more FDI is flowing not only from developed investment prospects for 2011–12, particularly companies on investment into developing economies but also from one about opportunities to invest in key developing location decisions. developing or transition economy to another. and transition economies (UNCTAD 2011a). Indeed, developing and transition economies’ share of global FDI inflows rose from roughly More FDI is flowing into developing and 19 percent in 2000 to 52 percent in 2010—for Figure transition economies than ever before the first time exceeding half the total (figure 1). 1 THE WORLD BANK GROUP Share of total FDI inflows And half the top 20 FDI recipients in 2010 were 2000 2010 developing or transition economies. Developing and transition 19% This is good news, because FDI accounts for economies a whopping 11 percent of global GDP and more 52% than 80 million jobs worldwide (UNCTAD 2010). Today there is greater potential than ever for devel- Developed 81% oping and transition economies to take advantage economies 48% of job creation and investment opportunities by attracting FDI. Global FDI inflows totaled US$1.24 trillion in 2010 (UNCTAD 2011b). They are pro- Source: UNCTAD 2011b. jected to reach US$1.4–1.6 trillion in 2011 and ATTRACTING FDI HOw MuCH DOES INVESTMENT CLIMATE MATTER? What drives decisions on where to invest? These limitations do not mean that we cannot Research has identified motivations driving draw some basic conclusions from the empiri- companies to undertake different types of FDI cal studies of FDI determinants. Looking at a set (USAID 2005): of 30 empirical studies that focus on developing n Natural-resource-seeking FDI—to gain access to and transition economies, and that have been a natural resource not available in the com- conducted since 2000, reveals some interesting pany’s home market. insights.1 The studies vary in geographic cover- n Market-seeking FDI—to gain access to new cus- age, with some focusing on transition economies tomers, clients, and export markets. in Eastern Europe and Asia, some on Africa or 2 n Efficiency-seeking FDI—to reduce production Latin America only, and some on single countries. costs by gaining access to new technologies Regardless of geographic focus, a majority of the or competitively priced inputs and labor. studies find that the size and growth potential n Strategic-asset-seeking FDI—to go after strategic of markets are significantly associated with FDI assets in a local economy, such as brands, new inflows (figure 2). technologies, or distribution channels. More interestingly, institutional and regula- However, these drivers do not highlight the tory quality (that is, the investment climate) and importance of the quality of institutions and regu- trade openness seem to matter. Many of the stud- lations in the host economy—that is, its investment ies identify measures of these features as being climate. This factor may be of more importance to significantly associated with FDI inflows. And foreign companies investing in the services sector. surprisingly, none of the studies identifies avail- ability of natural resources as significant. This Studies suggest a diverse set of factors may be because few of the studies focus explicitly In the past few decades hundreds of theoretical on FDI in natural resources, however, or because and empirical studies have attempted to pinpoint there are few or no cross-country indicators that the main factors in investors’ decisions on where measure the availability of natural resources as to invest. Most empirical work has found that mul- a whole. tiple factors are significantly associated with FDI inflows and that in some cases they interact. The New data sources confirm findings determinants identified as significant vary depend- Analysis based on new data sources confirms the ing on the countries, sectors, years, and types of findings of the review of empirical studies. investment studied. And many studies have been unable to overcome econometric identification Market size matters challenges. Thus a definitive understanding of There is no question that market size matters for what drives investment decisions would require attracting FDI. The world’s largest economies an understanding of the context for each FDI attract the most FDI. Together, the world’s 10 project. largest economies accounted for 47 percent of Figure Empirical studies show that market size and potential are significantly associated with FDI inflows 2 Market size and potential Institutional and regulatory qualitya 0 5 Studies citing factor as significant determinant of FDI 10 15 20 25 30 Trade openness Infrastructure quality Economic and political stability Labor quality and costs Cultural links Natural resource availability 0 Note: Many of the 30 studies identify multiple factors as significant. For a list of the studies, go to http://iab.worldbank.org/data/references. a. Includes a wide range of indicators, such as Kaufmann governance indicators, Doing Business indicators, Investing Across Borders indicators, International Country Risk Guide (ICRG) indexes, World Business Environment Survey data, and the Freedom House Index of Economic Freedom. Source: Authors’ compilation. all FDI inflows in 2010. The United States, the The investment climate clearly matters for the world’s largest economy, remained the top FDI location decisions of foreign investors (Mukim destination, receiving US$228 billion. Following and Nunnenkamp 2010). It is especially crucial is China, the most populous, which received more in determining the effectiveness of other factors than US$106 billion (UNCTAD 2011b). aimed at promoting inbound FDI, such as incen- tives. Although lowering effective tax rates can help Market potential may matter more boost FDI, the effect is eight times as strong for For developing and transition economies, per- countries with a good investment climate (James haps more important than market size is market 2009). Most important, the quality of the investment 3 growth potential. The economic growth expecta- climate may better allow for the beneficial spillovers tions based on population and income growth from FDI—providing the welfare gains through prospects mean that many emerging economies technology transfer to local suppliers that many offer foreign investors high potential returns on economies seek (Blalock and Gertler 2008). investment—and there has been an FDI boom in The World Bank Group’s Investing Across the world’s leading emerging markets. FDI flows Borders database, a new set of quantitative indica- into Brazil, the Russian Federation, India, China, tors comparing regulation of FDI around the world, and South Africa—the “BRICS� economies—have allows further analysis of the importance of invest- grown by an average 28 percent a year over the ment climate to FDI. Initial findings suggest that past five years. These five economies accounted economies with poor regulations and inefficient for 18 percent of the world’s FDI inflows in 2010, processes for foreign companies receive fewer new with a combined US$222 billion. FDI projects and smaller FDI inflows (figure 4). The market potential angle gives developing Analysis controlling for firm heterogeneity, country regions hope for future prosperity. This is espe- selection, market size, and quality of logistics infra- cially so for Sub-Saharan Africa, given its high structure finds a statistically significant relationship and relatively stable GDP growth in recent years. between FDI regulations and the value of inward Research by the McKinsey Global Institute (2010) direct investment (Wagle 2010). While the correla- suggests that Africa has more high-return invest- tion does not imply the existence or direction of a ment opportunities than any other developing causal relationship (because omitted variables may region. A survey by Ernst & Young (2011) forecasts better explain the relationship), it does suggest that FDI inflows for Africa of US$150 billion in 2015. investment climate is an important factor in foreign investors’ decisions on where to invest. But investment climate matters too With market size and potential held constant, Figure Market size and investment climate matter for the location of FDI what other factors seem to be important to for- eign companies seeking to invest in developing and transition economies? Evidence suggests that the investment climate matters quite a bit. For 3 Domestic market growth potential 0 Projects for which factor was most important determinant of location (% of total) 10 20 30 nearly 30,000 FDI projects in the fDi Markets Proximity to markets or customers database for which a location determinant is Investment climate identified, the investment climate (proxied by Availability of skilled workforce the dual factors of business regulations and gov- Presence of cluster, partner, or supplier ernment support) was the third most important Infrastructure and logistics investment motivation (cited in 12 percent of cases; figure 3).2 And improvements in the invest- Lower costs ment climate across the developing world may Technology and R&D infrastructure have aided the boom in FDI in developing and Quality of life, language skills transition economies. According to the World Natural resources, real estate Bank Group (2010), in the past five years about Note: Based on 28,814 new high-value-added FDI projects between January 2003 and July 2011 for which the determinant of 85 percent of economies made it easier to do location was identified. Source: Financial Times, fDi Markets database. business by reforming business regulation. ATTRACTING FDI HOw MuCH DOES INVESTMENT CLIMATE MATTER? A good investment climate for foreign Figure companies is associated with more FDI 4 Notes Average annual FDI inflows (US$ billions), 2006–10 30 1. For a list of the 30 studies, go to http://iab.world bank.org/data/references. 25 2. FDi Markets is an online database tracking cross- viewpoint 20 border greenfield investment in all sectors and coun- 15 tries worldwide (http://www.fdimarkets.com). 10 is an open forum to encourage dissemination of 5 References public policy innovations 0 Blalock, Garrick, and Paul Gertler. 2008. “Welfare Gains Lowest Highest for private sector–led and Economies ranked by IAB score, quintiles from Foreign Direct Investment through Technol- market-based solutions for ogy Transfer to Local Suppliers.� Journal of Interna- development. The views Note: Correlation is significant at the 5 percent level. The Investing Across Borders (IAB) aggregate score is the average of the share of total possible tional Economics 74 (2): 402–21. published are those of the points scored per topic. Ernst & Young. 2011. It’s Time for Africa: Ernst & Young’s Sources: UNCTAD, FDI Statistics database; World Bank Group, Investing authors and should not be Across Borders database. 2011 Africa Attractiveness Survey. Johannesburg and attributed to the World London. Bank or any other affiliated James, Sebastian. 2009. “Incentives and Investments: organizations. Nor do any Conclusion Evidence and Policy Implications.� FIAS, World of the conclusions represent Both a review of the empirical literature and Bank Group, Washington, DC. official policy of the World analysis using new data sources suggest that McKinsey Global Institute. 2010. Lions on the Move: The Bank or of its Executive business opportunities—as represented by, for Progress and Potential of African Economies. http:// Directors or the countries example, the size and growth potential of mar- www.mckinsey.com/. they represent. kets—are by far the most powerful determinants Mukim, Megha, and Peter Nunnenkamp. 2010. “The of FDI. But investment climate features such as Location Choices of Foreign Investors: A District- To order additional copies strong institutions and investor-friendly regula- Level Analysis in India.� Working Paper 1628, Kiel contact Ryan Hahn, tions also matter for developing and transition Institute for the World Economy. managing editor, economies seeking to attract additional FDI. In UNCTAD (United Nations Conference on Trade and Room F 4P-252A, The World Bank, a poor investment climate foreign investors and Development). 2010. World Investment Report 2010: 1818 H Street, NW, host economies may not be able to benefit fully Investing in a Low-Carbon Economy. New York and Washington, DC 20433. from business opportunities created by market Geneva: UNCTAD. size and growth potential. An economy that has ———. 2011a. Global Investment Trends Monitor No. 5. Telephone: a poor investment climate is therefore likely to January 17. New York and Geneva: UNCTAD. 001 202 473 4103 attract both less FDI and lower-quality FDI than ———. 2011b. World Investment Report 2011: Non-Equity Fax: it otherwise could. Modes of International Production and Development. New 001 202 522 3480 Moreover, many factors that are clearly impor- York and Geneva: UNCTAD. Email: tant in attracting FDI, such as market size and USAID (U.S. Agency for International Development). rhahn@worldbank.org availability of natural resources, cannot easily be 2005. Foreign Direct Investment: Putting It to Work in influenced by public policy. And other policy- Developing Countries. Washington, DC: USAID. Produced by Carol Siegel level drivers of FDI—such as human capital, Wagle, Swarnim. 2010. “Investing across Borders with the quality of infrastructure, and economic and Heterogeneous Firms: Do FDI-Specific Regulations Printed on recycled paper political stability—can be influenced only in Matter?� FPD Working Paper, World Bank Group, the medium to long run. In contrast, many ele- Washington, DC. ments of a country’s investment climate—such World Bank Group. 2010. Doing Business 2011: Making as the quality of its laws and regulations and the a Difference for Entrepreneurs. Washington, DC: World efficiency of its bureaucracy—can be affected in Bank. http://www.doingbusiness.org. the short run and at a comparatively low cost to government, providing an excellent opportunity for near-term benefits. This Note is available online: http://www.worldbank.org/fpd/publicpolicyjournal