Watch and learn

In the reinforcing role of investment in economic development and industrialisation, foreign direct investment is widely regarded as a key driver and enabler of industrial performance. But imbalances exist within both FDI inflow patterns and FDI stocks, at both global and regional levels. And developing countries face major issues in understanding the complex and continually evolving dynamics of FDI activity, and the need for clear, effective and cogent policies to attract and retain FDI.

These key issues concern not only how developing countries articulate policies and strategies to compete effectively for FDI – especially from the integrated international operations of multinational enterprises (MNEs) – but also ways in which developing countries can best harness motivations for FDI and thereby maximise the positive effects from it and minimise any negative spillovers. In this context, developing countries can learn much from south-east Asia’s relative success in attracting FDI.

The emerging issues within the dynamics of international capital flows and the organisational behaviour of the principal actors in the world economy – MNEs and the state – are best illustrated by the international business of FDI. With FDI accepted as a catalyst for economic growth, the industrial development plans of developing countries seek to articulate strategies for winning greater shares of global and regional FDI flows.

Empirical evidence

Notwithstanding the very real issues in FDI statistical concepts and definitions, methodological problems, and challenges of measurement, it is clear that global and regional flows and stocks have increased dramatically. However, substantive empirical evidence from economic, managerial and organisational studies points to the positive correlation between FDI and trade capacity, productivity growth, and industrial and export performance, as well as poverty reduction. The significant role of FDI in socio-technological and economic development was recognised and confirmed by the UN Financing for Development Conference in Monterrey, Mexico, in 2002. In spite of potential negative spillovers from FDI, policy choices are critical determinants in economic performance. Maximising positive externalities while moderating negative spillovers is important. FDI, and its policy environment, are therefore of crucial concern for policymakers in developing and industrialised countries alike.

In recent years, we have seen increasing competition for diminishing levels of global FDI. Simultaneously, there is increasingly dynamic cross-border configuration, reconfiguration and articulation of the manufacturing assets and servicing operations of international investors. The increasing complexity of FDI is demonstrated by the integrated international sourcing, technology, production, marketing and servicing networks of MNEs as inter-connected systems, which are geo-economically and spatially distributed.

Further, the distribution and performance of these networks is operationally and contemporaneously managed through strategic relations (co-operation, co-ordination, command and control) between subsidiaries and suppliers using information and communications technology. The systemic nature of MNEs’ networks leads to the emergence of asymmetric properties of, and synergistic relations between, the constituent elements (headquarters, regional headquarters, subsidiaries and outsource partner firms, etc.).

The global factory

In concert, the various network nodes responsible for manufacturing value-added transformations and the inter-relationships accountable for economic transactions, comprise what has been referred to as ‘the global factory’.

The global factory is co-evolving with the policy environment. It is characterised by inter-changeability and is in dynamic tension with its internal constituents as well as with external forces of competition and co-operation. Thus, the shape, boundaries and extent of the global factory and the industrial landscape it inhabits (and forms) are continuously changing, resulting in a complex system that approaches ‘self-organisation’.

The complexity of FDI and the global factory is therefore increasingly difficult to view through isolated economic and management disciplines. It is even more testing to capture in terms of data and information as well as FDI policy research and analysis; and investment promotion (IP) policy design and implementation.

This is especially so for developing countries and is due partly to the rapidly changing characteristics of industry competition and factor markets, and partly to the inadequate levels of capacity building in some developing countries. Competition is evolving into more internationally collaborative forms. And while capital and financial markets are global, the markets for goods and services are overwhelmingly regional. In contrast, most labour markets are national. Developing countries in general, and particularly those marginalised from FDI flows, often lack high-resolution instruments to calibrate and recalibrate their policies fast enough to keep pace with the rapidly changing context and dynamics of FDI, international production and markets.

FDI capture

UNIDO’s analysis of FDI shows south and east Asia capturing most of the FDI flows to developing countries. On average, south and east Asia attracted 7.0% of annual global FDI flows in the 1980s and 14.7% in the 1990s. In comparison, Latin America, the other best-performing region, attracted 7.9% and 9.4% respectively. In stark contrast, sub-Saharan Africa captured only 1.2% and 0.8% during the same respective periods.

In terms of transferable policy lessons from the success of south-east Asia in attracting FDI, since the first development decade of the 1960s, it must be acknowledged that initial geo-strategic conditions were crucially important.

As FDI and MNE responses have co-evolved with increasing complexity in organisational form and processes, there are a few notions up for for consideration. First, host-country policymakers need to take a systems view of FDI and MNEs and understand the structural dynamics therein in relation to industrial development objectives and strategies.

Secondly, as MNEs’ activities and systems co-evolve with the host environment, there is a pressing need for the host policy environment to reflect the global factory of MNEs.

Thirdly, the competition for FDI calls for host-country attention to increase the efficiency of doing business domestically (improving intermediation and lowering transaction costs).

Finally, developing countries need to accelerate from first, second and third generation IP to a new, fourth generation IP policy.

Next generation

Fourth generation IP should be seen as an adaptive response to the increasing complexity of MNEs, and is characterised by diminishing distinction between domestic and foreign investment activity in policy terms. Here, the thorny issue of incentives should be addressed by focusing on information and communications technology infrastructure, human resource development and social capital formation, and positioning strategic domestic sectors and sub-sectors within the interstices of the global factory and networks of MNEs.

The increasing international deployment of work manifest as global production sharing and vertical intra-industry trade has networked MNEs with supply chains, domestic firms and international small and medium-sized enterprises across geo-economic space. In a world of diminishing barriers to factor mobility, the reality of the global factory has profound implications for FDI policy and IP strategies of countries wishing to attract and retain FDI.

At a broad level, the long view of FDI indicates a change in the location decision, from the sequential to the parallel, in order to disintegrate and re-integrate differentiated stages of production and thereby maximise allocative and cost efficiencies, as well as maintain flexible access to markets. This calls on developing-country policymakers to create sensitive policy instruments and mechanisms to track the changing morphology of MNEs, with a view to targeting specific parts of their production networks.

The spatial relevance of free trade agreements for market seeking investments is crucial with respect to lowering transaction costs. The challenge posed to policy craft is how to: harmonise the ‘concentricities’ of ‘hard’ and ‘soft’ regulations that spill across the free trade agreements and bilateral investment treaties, double taxation treaties and regional trade agreements; cohere competitive policy instruments to attract FDI; and reduce the costs of doing business, while increasing the robustness of the assets and intellectual property rights regime.

The China dimension

The boundaries of international firms are increasingly fuzzy and permeable on the one hand, while internalisation of external factors and intermediate markets, on the other hand, tends to militate against market-based measures to influence the location decision. The China dimension presents complex policy challenges to south-east Asia as it attempts to compete with, and act as a viable complement to, China’s FDI trajectory. How south-east Asia deals with this successfully holds lessons for other developing countries with a giant neighbour.

The role of capital and financial markets and foreign portfolio investment is no longer tangential to FDI. The massive domestic savings profile of the region requires policies to create diversified financial assets that in turn will help spur the kind of domestic investment attractive to FDI in its more collaborative forms.

Graduation day

IP strategies, given the increasing complexity of FDI and its ‘real options’ decision-making, require a special sensitivity to the spatially distributed nature of FDI. Attention to the ‘virtuous cycle’ of policy intervention is essential to enable IPAs to graduate from first and second generation IP to third and fourth generation IP. Beyond targeting export-oriented FDI, fourth generation IP focuses holistically on the dynamics of ‘the global factory’ of MNEs and aligns modal neutrality, market contestability and policy coherence in the reform of regulations.

It also takes a much broader and strategic view of the role of IPAs beyond the traditional focus on the ‘foreign’ in FDI attraction, advocacy, facilitation and regulation of entry. It is geared towards actively championing promising domestic firms in the supply chain and networks of MNEs and international small and medium-sized enterprises; and enabling cross-ministerial co-ordination in setting the regulatory regime.

Furthermore, FDI policy needs to be increasingly coherent with a country’s industrial development trajectory. Therefore, attention to the overall system of national (and regional) economic incentives – with respect to the national innovation system, science, technology and innovation policy, human resources, and social capital formation in relation to FDI – is also necessary.

The successful south-east Asian development experience thus far – and the challenges it faces in the future, and the central part played by MNEs and FDI inflows and their linkages to domestic investment – hold significant lessons for other developing regions.