By 2015 it was clear that Mongolia had a serious problem. This vast country of steppes and desert was hit by a double whammy that sharply curbed economic growth. From 2014 to 2016, commodity prices crashed. This, coupled with falling demand from neighbouring China, battered Mongolia’s economy, and growth dropped to 1.2% in 2016.

This was a rapid reversal of fortune: over the preceding two decades, Mongolia had transformed itself into a democracy while trebling per-capita GDP. School enrolment had increased dramatically, while maternal mortality had fallen.

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Mongolia was on the right track. However, its economy was not diversified, either in terms of export partners or sectors generating economic activity and revenues. China takes 95% of its exports, of which 83% are commodities, mostly coal and copper, both of which were battered in the price crash. Mongolia's nascent non-mining economy, meanwhile, was hit by a precipitous fall in FDI and weakening consumer demand.

Back in business

Mongolia’s growth has since recovered, mostly on the back of stronger copper and coal prices. GDP growth rebounded to 6.3% in the first half of 2018, a rate that can start to make a serious dent in poverty. FDI, too, made a comeback.

However, the country’s experience highlights the vulnerabilities of developing economies as they look to diversify – or fail to. Managing this in conjunction with natural resource revenues can be especially challenging for some: the windfall revenues these industries provide can create cycles of dependence, and in some cases disincentivise policy change and investment into other sectors.

As developing economies become further enmeshed in the global economy, they reap the benefits. However, volatility is a constant risk for those that are less diversified. “Openness itself has a direct and positive effect on income volatility,” writes Marion Jansen, now the director of the market development division at the International Trade Centre, in a paper for the World Trade Organization. “If small economies were able to diversify their exports, they could therefore reduce income volatility. This would in turn be likely to have a positive impact on growth, because income volatility has been shown in the economic literature to be bad for growth.”

Driving towards diversity

Economic diversification is defined by the UN as the process of moving an economy away from a single source of income to multiple sources spanning different sectors and markets. While historically the primary aim has been achieving steady growth and generating jobs, diversification will take on an additional dimension as countries worldwide look to limit the impact of climate change.

“It takes on a new relevance as a strategy to diversify away from vulnerable products, markets and jobs towards income sources that are low-emission and more climate resilient,” according to the UN Climate Change secretariat.

But how can countries achieve diversification, especially in contexts where domestic capital and government resources may be limited? Here, FDI has a large role to play.

Commodity complications

Diversification is often the cornerstone of national development strategies, and as many parts of the global economy stagnate the need to diversify is all the more urgent. “These trends weigh heavily on countries that depend on the production and export of a small range of products, or that sell products in only a few overseas markets,” notes the World Bank.

Among developing countries, the degree of diversification is hugely varied. Chile and Zambia, for example, have similar population sizes and are richly endowed with natural resources, in particular copper. However, Chile exports some 2800 products to 120 countries. Zambia exports just 700 to about 80 countries. The result shows in their GDP figures: while Zambia’s GDP totalled $25.9bn in 2017, Chile’s was $227.1bn over the same period.

Overdependence on commodities can hamper diversification in other ways: namely, that the boost this can give to local currencies during a boom can undermine the competitiveness of new export industries.

Investment in infrastructure can help smooth out the boom-and-bust cycle and streamline processes for new industries. “Declining trade costs and increasingly efficient trade logistics were at the heart of the success of east Asian countries in integrating into the regional and global economy and achieving more diversified economies,” World Bank researchers note.

Here FDI can play a valuable role, provided the right structures are in place. Major infrastructure corridors linking countries in eastern and southern Africa to ports and railway systems, for example, have mostly been privately financed. The Mombasa-Nairobi and Addis Ababa-Djibouti railway lines, both recently inaugurated, were largely financed and built by Chinese state-owned and privately owned banks and construction companies.

Downward pressure

Across Latin America and Africa, as well as Asia, there is a trend towards the privatisation of state-owned utilities and building out additional power generation and grid capacity with private partners.

Here, countries have to find a balance to ensure public services are not completely captured by private interests. “The natural monopoly characteristics of infrastructure utilities mean that the privatisation of these industries risks the creation of private sector monopolies,” write academics Colin Kirkpatrick and David Parker in a research paper.

This can in turn have a dampening effect on overall FDI into the country. “Where regulatory institutions are weak and vulnerable to ‘capture’ by the government (or the private sector), foreign investors may be more reluctant to make a major commitment to large-scale infrastructure projects in developing countries,” they conclude.

Of course, while attracting private capital is key, there will be cases when the government has to step in. Developing infrastructure to link Indonesia’s 17,000 islands is a case in point. “If you want to simply build a new sea port in Java or expand existing sea ports, you can go to state-owned enterprises or the private sector. You don’t have to go to the government budget,” says Bambang Brodjonegoro, the country’s minister of national development planning.

In order to link more remote islands with the country’s economy, however, the government will often have to step in. “The government, through our agency, will do its best for the areas that might not be appealing to the private sector. We know there are many isolated islands that still need connectivity and that is the main job of the government,” says Mr Brodjonegoro.

Special economic zones (SEZs) are another strategy employed by developing countries looking to attract new industries and promote industrial clusters. Many wealthier, late-developing countries relied heavily on SEZs to build industrial bases by attracting and protecting FDI.

These were key to industrialisation in the likes of China, India and Malaysia, as well as in what are now highly developed countries such as South Korea and the United Arab Emirates. The UN notes the successes of Mauritius and the Dominican Republic, two island economies, in using SEZs to transition their economies from primarily agrarian to include manufacturing.

Making the market

Even economies that have previously achieved diversification are having to stay vigilant so as not to become victims of their own success. Vietnam is one example. Over a 30-year period, Vietnam’s pro-market reforms have ushered in a transformation in the country's economy.

Previously impoverished following decades of conflict and foreign intervention, the country eased foreign investment restrictions and guided capital into key sectors including manufacturing.

Cheap labour, ample natural resources and the promise of high returns brought in investors, as did the country's accession to the World Trade Organization in 2007. Year on year, Vietnam's FDI flows trebled from 2006, according to Focus Economics.

Now, however, Vietnam is at a crossroads as labour costs rise and poverty alleviation plateaus. The government, therefore, is looking to leverage FDI flows to build more advanced, value-added industries. Boosting FDI into hi-tech and environmentally conscious industries is a key goal in the government’s current five-year plan.

Vietnam's automotive and conservation technology sectors (such as water conservation, and solar and wind energy) are medium-term priorities, with pharmaceuticals and medtech, IT and financial services seen as longer term objectives. So far that seems to be bearing fruit: in 2018 Vietnam attracted $28.8bn in greenfield FDI, according to investment monitor fDi Markets. Investments into financial services garnered the most projects, while the largest volume of capital invested went into real estate.

Promotion, not competition

For smaller developing countries trying to bring in key investors to new sectors, it is easy to get sucked into comparison and competition with neighbours. This is a tactic that some regional and national investment promotion agencies say is damaging. In India, for example, the national investment promotion authority (IPA) spends a lot of time and energy trying to co-ordinate strategy and messaging among subnational IPAs that, critics claim, could be spent gaining investment.

In the Caribbean region, the regional IPA – Caribbean Export Development Agency – is keen to push for inter-regional projects and to promote a cohesive image. This is especially important as it looks to establish cross-regional value chains. “The idea is that we cannot compete either in quantity or volume [with larger neighbours], [so we are] looking to invent unique products that enhance the image of the Caribbean,” says Escipion Oliveira Gomez, deputy executive director of the Caribbean Export Development Agency.

The Caribbean Association of Investment Promotion Agencies is actively working to prevent a race to the bottom as countries compete for investment. “What I fear the most is that countries start competing with each other on concessions, then you start making deals that are not beneficial in the end,” says Mr Gomez. “If one country starts giving too many concessions and lowering taxes, everyone will suffer in the medium term. The proposition [to investors is] this is a good place to live, a good place to bring your family.”

Industries such as bespoke tourism, design and textiles, and high-quality rum and cocoa product lines, are targets, with production lines sometimes spanning several countries. And while investment from major economies is important, south-south investment is on the rise. Mr Oliveira is especially keen to promote inter-regional investment.

“It’s not only bringing funds from Europe, the US and Asia, it’s about keeping wealth from this region in the markets,” he says. “The [most important] thing is: don’t sell out your region.”

In focus: Developing countries and diversification through FDI by James Zhan, head of the investment and enterprise division of Unctad

Economic diversification is a challenge for all developing countries, and more so for small developing economies. Small internal market sizes mean that these countries tend to be more dependent on international markets. They are therefore more vulnerable to exogenous shocks, whether economic, financial or climate change related.

The experience of countries that have benefited from Unctad’s investment policy review and technical assistance programme shows that, when the appropriate policies are adopted and effectively implemented, FDI can be a powerful vehicle for economic diversification and sustainable development. 

Mauritius' major impact

Small, insular economies such as Mauritius, for example, have been successful in attracting export and efficiency-seeking FDI, which has had a major impact on economic diversification. When the government of Mauritius requested that Unctad carry out an investment policy review 20 years ago, the country had been pursuing a successful development path, from a commodity-producing economy based on sugar to a leading manufacturing exporter in sub-Saharan Africa. By then, Mauritius had established itself as a middle-income developing country and had entered the league of outward investors as its firms began to establish operations in lower wage sites in the region.

While Mauritius had received little FDI in nominal terms, the influx of foreign firms had nonetheless been critical to its first structural transformation. The review recommended several reforms to upgrade and intensify the country’s diversification drive by increasing value addition in well-established industries (such as textiles and garments, sugar, tourism and fisheries) and expanding services into new areas of higher value.

Since then, the majority of the review’s recommendations have been implemented, and Mauritius has undergone a second structural transformation through the development of a globally competitive services sector. Mauritius has also become a regional leader in the IT sector, hosting hundreds of BPO enterprises, including several global players. The marine sector has continued to expand, and Mauritius is now a destination of choice in the high-end tourism market. The country has also made significant progress on several development indicators, including poverty reduction, life expectancy, educational attainment and health. All of these factors have made Mauritius a development success story.

Diversifying the Dominican Republic

Another example of a country that has successfully diversified its economy through FDI is the Dominican Republic. Since the 1980s, the Dominican Republic has adopted policies of greater openness to international trade and investment as part of its quest for economic and social progress. FDI led the transition of the country’s export base from commodities to basic manufacturing and services. It also played a major role in making the Dominican Republic a leading tourist destination.

In the early 2000s, the Dominican Republic sought to direct the economy towards a new stage of development, based on higher value addition in both manufacturing and services. The government recognised that FDI could remain instrumental in supporting this evolution. The key policies and initiatives adopted aimed at changing the country’s supply from one based on a pool of low-cost labour and fiscal incentives to one based on the excellence of its investment climate and the quality of its infrastructure. In addition, the country successfully attracted international investment into new industries such as electronics, ICT, medical devices and BPO.

In resource-rich countries, economic diversification is a particular challenge, but the example of diamond-rich Botswana shows that good governance, a sound investment climate and proactive policymaking can be instrumental in avoiding the resource curse and supporting diversification. The revenues from FDI in Botswana's diamond sector have been channelled into physical and social infrastructure development to support economic activity in other areas. The contribution of the services sector to GDP has increased in the past few decades, particularly those activities led by FDI, such as trade, hotels and restaurants as well as banks, insurance and business services. Links between businesses have been actively developed, the most notable being the development of the downstream diamond sector, which led the industry to be the largest manufacturing sector in the country and an important employer.

Unctad’s investment policy review has supported the government of Botswana’s efforts in building a positive and open investment climate to attract FDI. Among other things, the review contributed to the establishment of key institutions to attract and benefit from FDI, such as a competition authority, as well as a fully fledged investment promotion agency that engages in proactive and selective investor targeting based on research aimed at identifying growth sectors in the economy.

In my view, small developing economies are structurally vulnerable, but diversification is possible through FDI. What is needed is a strong leadership, a sound development strategy and an effective government. The starting point is a change in mindset: a tiny island can be a huge ocean state; a small landlocked country can be a big transit business hub.