Searching for the Holy Grail? The quest for identifying a “good investment climate” (May 2012)

Rethinking Bretton Woods | Wed, May 2, 2012

By Aldo Caliari and Christina Weller

An event cosponsored by Center of Concern and CAFOD in Doha, Qatar, offered a good opportunity for discussing investment climate reforms and their development impacts.

At an event held on April 24, 2012, in the occasion of the UNCTAD XIII Conference, Doha, Qatar, participants exchanged views on the theme Searching for the Holy Grail? The quest for identifying a “good investment climate.” The event, cosponsored by Center of Concern and CAFOD, offered a good opportunity for discussing investment climate reforms and their development impacts.

One of the issues under discussion was the extent to which a country’s policy and legal framework, and related reforms, act as drivers for foreign investment. Elisabeth Tuerk from UNCTAD’s Division on Investment and Enterprise noted that a country’s regulatory framework is one among several factors that determine foreign investment inflows into a country. Economic determinants, such as the size of the market, the cost of resources (e.g. labor), the availability of natural resources and business facilitation measures interact with a country’s regulatory environment and together, determine a country’s attractiveness for foreign investment.

Other participants were more skeptical of the importance of the regulatory framework. In the case of Africa, studies have shown that in spite of many reforms being implemented, investment had not come. This has led to the conclusion that FDI also presupposes a level of resources, and below a certain threshold no matter what reforms are introduced, FDI is unlikely to come.

But the very assumption that attracting more foreign investment would always be good for development received considerable scrutiny during the discussion. Indeed, the aim of many governments in implementing investment climate reforms, and standard advice for example from the World Bank’s Doing Business rankings, were biased in favour of attracting foreign direct investment. The expectation was not borne by the experience, though. In several countries FDI has been the source of problems such as capital flight and increased debt. This because the policies to attract investors often included free repatriation of profits, so the more successful the investment – in terms of returns—the more likely it will generate an outflow of capital that would strain the balance of payments. Adding to this potential loss of capital were the tax incentives. One participant complained about the tax incentives that eroded the revenue base, oftentimes without being traded for any clear benefit.

Mariama Williams, staff of the South Centre, said that “as we study the countries with the most successful development policy, what we learn is how little FDI they relied upon, initially.” In truth, FDI is usually presented as a complement to domestic savings. But, said Ms Williams, “they become oftentimes a substitute, not a complement. We need more disaggregated data by sector to find out where it is more likely to play one or another role.”

Another problem with investment climate reforms is that their design often neglects the economic importance and development potential of the domestic sector, in particular small businesses. These businesses in fact represented a much greater source of capital formation, employment and even economic transformation. Helping these businesses also had a greater correlation with poverty reduction, because of their tendency to be labour intensive.

“Nothing is more unequal than equal treatment of unequal people,” said Ms Christina Weller, analyst at the UK-based agency CAFOD, alluding to the potentially diverging paths reforms could take if oriented to the small and domestic entrepreneurs, rather than the large ones.

Drawing on first hand consultations her agency had carried out in several low income countries, she said that export or other tax incentives that were promoted in the Doing Business model worked for some foreign investors but would not make any difference for small entrepreneurs who could not benefit from such loopholes and, instead, relied more on publicly-financed services.

“Even reforms that might appear as innocuous could be harmful for small businesses as they will entail trade-offs in context of limited resources and capacities in the public sector,” she said.

Where investment comes, it should be guided into linkages with the domestic companies. But this does not happen automatically, as attested by the case of Jamaica, where local business development has not happened in spite of years of investment climate reforms.

Investment climate reforms miss the point in Africa, said Tetteh Hormeku, of TWN-Africa. Eighty percent of agriculture—which is the main stay of most Africa economies – is small holder agriculture, that is, based on less than one acre plots, with minimal technology, little irrigation, and poor infrastructure.  The challenge of transformation posed by this requires multiple interventions across various economic sectors.  “For this, foreign investment needs to be directed, as part of a twin strategy of agrarian transformation and industrialization, based on building overall domestic productive capacities, not simply attracted and embraced in whichever way it comes”  

Participants did have suggestion for alternatives to the standard blueprint investment climate, which they agreed does not work. Whilst FDI can still bring benefits, there is a need for a more targeted approach to boost the small-scale part of the economy. This could lead to a different policy mix and set of priorities than in the current standard approach, for example, preferential treatment in procurement policies, promotion of linkages with incoming investors and better rural infrastructure.

It is clear that UNCTAD has a unique role to promote a development-centered approach to the investment climate, and a more balanced approach to meeting the needs of domestic, small-scale business as well as FDI. The challenges are big but UNCTAD should claim its role as leader in the development of a new consensus around a development-centered approach to investment climate reforms.