NOTE NUMBER 273
P U B L I C P O L I C Y F O R T H E
privatesector
SEPTEMBER 2004
Vincent Palmade and
Andrea Anayiotas
Vincent Palmade
(vpalmade@ifc.org) is a
lead economist at the
Foreign Investment
T H E W O R L D B A N K G R O U P PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY
Advisory Service in the
Private Sector
Development Vice
Presidency, a joint facility
of the World Bank and
International Finance
Corporation. Andrea
Anayiotas is a consultant
with the Foreign
Investment Advisory
Service.
FDI Trends
Looking Beyond the Current Gloom in Developing Countries
T h e f a l l i n f o re i g n d i re c t i nve s t m e n t ( F D I ) s i n c e 1 9 9 9 , a n d C h i n a ’s
g row i n g s h a re , wo r r y m o s t d eve l o p i n g c o u n t r i e s . B u t a n i n - d e p t h l o o k
reve a l s n ew a n d p ro m i s i n g t re n d s . T h e d e c l i n e i s l a rg e l y a o n e - t i m e
a d j u s t m e n t f o l l ow i n g t h e p r i vat i z at i o n b o o m o f t h e 1 9 9 0 s . F D I i s
c o m i n g f ro m m o re c o u n t r i e s — a n d g o i n g t o m o re s e c t o r s . T h e
c o n d i t i o n s f o r at t r a c t i n g F D I va r y by s e c t o r : i n l a b o r - i n t e n s i ve
m a n u f a c t u r i n g , f o r ex a m p l e , e f f i c i e n t c u s t o m s a n d f l ex i bl e l a b o r
m a r ke t s a re key, w h i l e i n re t a i l a c c e s s t o l a n d a n d e q u a l e n f o rc e m e n t
o f t a x r u l e s m at t e r m o s t . S o r t i n g o u t t h e m i c ro e c o n o m i c i s s u e s by
s e c t o r w i l l b e g o o d n o t o n l y f o r F D I b u t a l s o f o r d o m e s t i c i nve s t o r s .
The flows of foreign direct investment (FDI) to remained low. Eastern European countries are
developing countries have declined by 26 per- counting on integration with the European
cent since 1999, while China’s share has Union to help renew FDI flows.
increased from 21 percent to 39 percent (figure
1). The large flows of FDI to banks and utilities Reasons for hope
dwindled following a series of disappointments But a more in-depth look suggests a more com-
for both investors and governments. China now plex and hopeful story. Despite the decline in
has a commanding lead in manufacturing, with FDI since 1999, its growth over the past 13 years
a large, qualified, low-cost, and flexible work- has been phenomenal, averaging more than 17
force. India seems to be following suit in the percent annually in dollar terms. The decline
promising offshore services sector. since 1999 is due mostly to the drop in FDI fol-
As a result of all this, many developing coun- lowing the boom in huge (one-time) privatiza-
tries regard their prospects for FDI as bleak. tion deals in the infrastructure, financial, and
The gloom is particularly strong among Latin petroleum sectors in the 1990s. FDI in other sec-
American and Southeast Asian countries, once tors remained fairly constant (figure 2). This
the darlings of foreign investors. FDI levels in cyclical effect is confirmed by the much starker
Africa, the Middle East, and South Asia have “rise and fall” pattern in FDI flows to industrial
F D I T R E N D S LOOKING BEYOND THE CURRENT GLOOM IN DEVELOPING COUNTRIES

Foreign direct investment flows to to excessive returns. The financial and infra-
Figure developing countries, 1990–2003 structure sectors are tricky to regulate as quasi-

1 US$ billions
200

150
All other
100 developing
countries
50
2 China
0 petition and investments, resulting in a
1990 1992 1994 1996 1998
a. Estimated.
Source: World Bank 2004.
countries over the same period. Another (hope-
fully one-time) factor driving the decline has
been the macroeconomic crisis and uncertain-
ties affecting Latin America.
Positive impact on development
While many observers believe that much of the
FDI in the financial and infrastructure sectors
yielded little impact, this perception does not
stand up to in-depth analyses such as those by
Luis Guasch (2002), Clive Harris (2003), and
the McKinsey Global Institute (2003). These
studies have shown that in almost all cases FDI
had a largely positive impact on productivity
(the key criterion for assessing long-term eco-
nomic performance) and on the coverage of
services. But ill-designed privatization processes,
contracts, and regulations have often led to
poor returns on investments or, in some cases,
natural monopolies, but FDI is not to blame for
government shortcomings.
In sectors where competition is stronger, FDI
has had a much more obvious positive impact. A
study of India by the McKinsey Global Institute
(2001) showed that the removal of FDI restric-
tions in the automotive sector unleashed com-
2000 2003a threefold increase in productivity that trans-
lated into a threefold increase in output due to
falling prices (figure 3). Employment also rose.
So, once adjusted for the one-time events and
government shortcomings, the fundamental
picture of FDI is quite positive.
China in perspective
China’s commanding FDI performance also
should be put into perspective. While China
accounts for 39 percent of the FDI to develop-
ing countries, it also accounts for almost 30 per-
cent of the developing world’s population. In
fact, relative to GDP, China’s performance in
attracting FDI is good but not extraordinary,
with FDI at 3.8 percent of GDP in 1999–2002.
Nineteen developing countries did better over
the same period. China’s performance looks
even less extraordinary if adjusted for the
round-tripping of FDI through Hong Kong
(China), which some estimates suggest may
account for as much as 30 percent of total FDI
to China.

Foreign direct investment flows to 20

New diversity in sources and destinations
largest developing country recipients Another reason for hope is that the sources of
Figure by sector, 1998–2002 FDI are increasingly varied. “South-south” FDI

2 US$ billions
200

150
flows are expanding rapidly; they now account
for more than 30 percent of FDI to developing
countries, up from 17 percent in 1995. China
and South Africa are becoming major players in
Infrastructure, financial, and petroleum sectors Africa, for example, with about US$2.7 billion
100
and US$1.6 billion of FDI there by 2001, the lat-
50 Other sectors est year for which statistics are available.
That developing countries are growing
0
1998 1999 2000 2001 2002 sources of FDI is doubly good news because
these new players tend to be better equipped to
Source: Economic Commission for Latin America and the Caribbean, Association of
Southeast Asian Nations, United Nations Conference on Trade and Development, invest in difficult and remote markets and to
and government statistics.
develop products and services better adapted to
 Impact of foreign direct investment in the Indian automotive industry
Figure Index: 1992–93 = 100
3 Barriers
removed
• Licensing
Labor productivity
abolished
• FDI allowed
100
1992–93
Source: McKinsey Global Institute 2001.
developing country consumers. The Turkish
conglomerate Koc was the first company to
open hypermarkets in the Russian Federation—
with great success. Chinese electronics produc-
ers such as TCL know how to produce US$50
color televisions in India and Vietnam, while
Maruti Suzuki in India is ready to export cars for
US$2,000. These are low-spec products, but they
are exactly what consumers in developing coun-
tries need, as they often face the unhappy choice
between high-spec but unaffordable “Western”
products and very low-spec but relatively expen-
sive traditional products.
Yet another reason to be hopeful is that the
destination sectors of FDI also are becoming
more varied. FDI has evolved from focusing pri-
marily on natural resources, infrastructure, and
manufacturing (export-driven or “tariff jump-
ing” investment) to also covering banking, retail,
construction, tourism, and offshore services.
Cumulative FDI flows to the retail trade sector in
the 20 largest developing countries amounted to
US$45 billion in 1998–2002 (about 7 percent of
the total to these countries). That too is good
news, since more and more countries can hope
to develop comparative advantages in a few of
these new sectors. Moreover, FDI is increasingly
market seeking rather than efficiency seeking
(that is, export driven), offering opportunities to
any country willing to open its markets or inte-
grate with its neighbors.
These encouraging FDI trends in the devel-
oping world should be expected to continue,
since they mirror what has happened in the
industrial world.
356
Output
380
Employment
100 100 111
3
1999–2000 1992–93 1999–2000 1992–93 1999–2000
Implications for governments
So there is no reason for developing countries
to despair. But in an increasingly competitive
market, getting their fair share of FDI flows and
benefits will be hard work. Attracting FDI will
require a shift in mind-set for most developing
country governments.
Broadening the scope of FDI
To start with, the scope of efforts to attract FDI
must encompass all economic sectors. The ten-
dency in the past was to focus almost exclusively
on infrastructure and on efficiency-seeking and
tariff-jumping FDI in manufacturing. In the
future more and more FDI will be market-
seeking investment in service sectors as well as
investment in tourism and offshore services.
Most developing countries continue to restrict
FDI in service sectors (for example, India does
not allow FDI in retail), yet are ready to waste for-
tunes to attract efficiency-seeking FDI for manu-
facturing in an uphill battle against China.
There is a general misconception that
market-seeking FDI in domestic sectors such as
retail yields little development impact. The
opposite is true. FDI in retail has been a key
driver of productivity growth in Brazil, Poland,
and Thailand, resulting in lower prices and
higher consumption. Large-scale foreign retail-
ers are also forcing wholesalers and food proces-
sors to improve. And they are now becoming
important sources of exports: Tesco in Thailand
and Wal-Mart in Brazil are increasingly turning
to local products to feed their global supply
chains. Retail also happens to be a pillar of the
F D I T R E N D S LOOKING BEYOND THE CURRENT GLOOM IN DEVELOPING COUNTRIES

tourism industry. The misconceptions about FDI Note

are made worse by political economy factors:
while attracting efficiency-seeking FDI does not
affect incumbents, attracting market-seeking
FDI usually does.
Tackling microeconomic issues
In addition to broadening the scope of efforts,
countries must recognize that the battle for FDI
will increasingly be fought at the microeconomic
level sector by sector. Of course, foreign
investors will continue to insist on basic political
and macroeconomic stability, but this should
become less important as a differentiating factor.
Investors will look increasingly at micro-
economic conditions, and what they look for will
vary significantly from one sector to another.
The requirements for efficiency-seeking
investment in manufacturing are increasingly
well understood—low factor costs, a flexible
labor market, a small regulatory burden, effi-
cient infrastructure and customs. Less obvious
factors include easy access to a competitive sup-
1. The importance of microeconomic barriers to growth
has been documented in great detail by the World Bank’s
Investment Climate Assessments (http://www.world
bank.org/privatesector/ic/index.htm) and Doing Business
studies (http://rru.worldbank.org/Doing Business/) as
viewpoint
well as by the McKinsey Global Institute’s industry-level
analysis (http://www.mckinsey.com/knowledge/mgi/).
is an open forum to
encourage dissemination of
References
public policy innovations for
Guasch, Luis. 2002. “The Experience of Latin America
private sector–led and
with Performance-Based Contracts.” World Bank, Latin
market-based solutions for
America and the Caribbean Region, Finance, Private development. The views
Sector, and Infrastructure Unit, Washington, D.C. published are those of the
Harris, Clive. 2003. Private Participation in Infrastructure authors and should not be
in Developing Countries: Trends, Impacts, and Policy Lessons. attributed to the World
World Bank Working Paper 5. Washington, D.C. Bank or any other affiliated
McKinsey Global Institute. 2001. India’s Growth organizations. Nor do any of
Imperative. Mumbai. the conclusions represent
———. 2003. New Horizons. San Francisco. official policy of the World
World Bank. 2004. Global Development Finance 2004: Bank or of its Executive
Harnessing Cyclical Gains for Development. Washington, D.C. Directors or the countries
they represent.

plier base and business service providers.

The factors required to attract FDI in domes- To order additional copies

tic services are vastly different—a stable and contact Suzanne Smith,

smart regulatory environment for quasi-natural managing editor,

Room I9-009,
monopolies (a hard-won lesson from the
The World Bank,
1990s), functioning land markets for retail,
1818 H Street, NW,
hotels, and construction. In addition, unfair
Washington, DC 20433.
competition from tax-evading, low-productivity
informal players has been found to be among
Telephone:
the biggest constraints to FDI growth in domes-
001 202 458 7281
tic services in most developing countries, and it
Fax:
tends to get worse over time.1
001 202 522 3480
Resolving the microeconomic issues sector Email:
by sector will be good for FDI as well as for ssmith7@worldbank.org
domestic private investors—and thus key to
boosting growth and reducing poverty. But most Produced by Grammarians,
developing countries have a long way to go. Inc.

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