The issue of policy making for FDI is seen as a very challenging task. This is especially true in context of BRIC nations, most of who were forced into paradigm shifts from import substitution to liberalization rather than natural adoption of it. Be it the fall of the Soviet Empire, the Indian and Brazilian economic crisis of 1980s and 90s or the reforms undertaken by Deng Xiaoping to correct the economic malfeasance that riddled China, the 4 emerging economies were coerced into changes.
There has been considerable amount of quantitative and qualitative work done on the subject of FDI policy formulation by think tanks around the world and in particular by theOECD. The paper that tends to stand out as the modus operandi of FDI policy making by OECD is written by Charles Oman called ‘Policy Competition for Foreign Direct Investment : A Study of Competition among Governments to Attract FDI’. This paper analyzes the process of FDI policy making through the prism of competition between different governments.
According to Oman the level of competition between governments for FDI inflow can have both positive and negative effects on the host country’s economy. The consequences of which can be analyzed with the help of two game theory models (Oman, 2000):
a) Positive-sum Game Hypothesis
b) Negative-sum Game Hypothesis
Positive-sum Game Hypothesis: Both the positive and negative-sum game hypothesis refer to the net outcomes of competition. In the case of a positive-sum game competition leads to net benefits for investors and host economies alike. According to Oman, investors give greater importance to “fundamentals” such as political and macroeconomic stability, market access and long term growth potential as and availability of skilled workers as opposed to receiving fiscal or financial incentives. Therefore this greater preference that is given to “fundamentals” by investors forces governments to prioritize these areas as central piece of their policy in order to ensure they are competitive with rival governments. This overall capacity generation due to policy changes tends to have a net positive effect on the economy even in the absence of inflow of FDI:
“Thus, in addition to inducing governments individually and collectively to pursue actions that enhance their economies’ growth and productivity levels even in the absence of additional FDI, according to the positive-sum game interpretation, those actions are likely to induce an increase in the global supply of investment and FDI— independently of the extent to which investment is diverted from one country to another by those actions. Also, because FDI can produce significant spillover benefits for the host economy, this increase in global FDI brings up the level of global FDI from a sub-optimal level to one that is closer to socially optimal.[1] On all accounts, then, according to the positive-sum game interpretation, intensifying competition among governments to attract FDI should prove beneficial, on balance, both to investors and to governments, and to society as a whole.”
Negative-sum Game Hypothesis: The negative-sum game hypothesis sees competition as producing net loses. This is due to the phenomenon of “prisoner’s dilemma” that is created due to the nature of competition. According to Oman, “as the competition heats up, governments come under increasing pressure to engage in costly “bidding wars” that leads them continually to increase the level of public subsidies offered to investors — fiscal and financial “incentives” — until that level far surpasses any that could possibly be justifiable from society’s perspective (even taking account of the possible spillover benefits to be derived from additional global FDI).” Even if it is in the best interest of governments not to engage in a bidding war the lack of homogeneity between the economic realities under government’s control forces them to engage in a bidding process in order to ensure FDI does not flow into the competitor’s domain instead.
This competition can be destructive in nature because the public funds used to pay incentives tend not to cover the benefits received from FDI and also possess long term consequences in the form of opportunities costs in building manpower and infrastructure capacities. Another argument that can be made is that competition among government can lead to compromise on environmental laws and worker rights which may result in exploitation.
Conceptually speaking, Oman derives some very interesting inferences from negative-sum hypothesis in the sense that it helps him distinguish between “incentives based” and “rules based” forms of competition. He further classifies the basis of incentives into two categories:
a) Fiscal Incentives – referring to reduction in income tax rate for certain activities, tax holidays, exemption from import duties, deductions from gross earnings etc.
b) Financial Incentives – grants, subsidies, loans and loan guarantees.
Here it is important to note the distributive and redistributive aspects of Lowi’s typology that we saw earlier in effect in classifying suitable policies.
Rules based competition covers the remaining policy categories such as rules for worker’s rights, environmental protection acts, and property law enforcements, establishment of “export processing zones” (EPZ) and special economic zones (SEZ) as well as privatization of state owned markets.
Thus based on the hypothesis model the type of competition inducing mechanism chosen (rules based or incentive based) will produce an overall net benefit as in the case of positive sum hypothesis or net loss as in the case of negative sum hypothesis.
Another paper written in 2002 on the topic is by Hans Christiansen for OECD called‘Checklist for Foreign Direct Investment Incentive Policies’ furthers the theoretical concepts established on relationship between FDI and competition. It also explores the pervasive problem of a lack of common language and conceptual murkiness of FDI policy making (Christiansen, 2003). The report gives insight into rules based approach to FDI that creates different rules for different investors (by nationality) and its overlap with specific approach that create incentives for individual foreign investors or investment contexts. These again can have positive and negative effects. Positive in the sense that it can act as an encouragement to expand for existing firms and discourage them from moving away and negative if the level of discrimination between competing firms caused by these laws is high.
An important aspect covered in the paper relates to the nature of competition where competition refers to changes in incentives offered by a host country due to incentive strategy of another country. Christiansen classifies this into two types:
a) Target competition: in which governments are competing for specific FDI projects by trying to outbid each other.
b) Regime competition: where governments compete on overall FDI objectives.
The report next explores the difference between a wasteful and an effective strategy. In order to understand this concept a thorough cost-benefit analysis is needed by policy makers and they must be able to incorporate the spillover effects in their assessment models. The spillover effects were classified into 5 types: 1) act as a trigger for transfers of technology and know-how; 2) assist enterprise development and restructuring, not least in connection with privatization; 3) contribute to fuller international (trade) integration; 4) bolster business sector competition; and 5) support human capital formation in the host country. In the event that FDI inflow has no spillover the paper suggests a generic strategy to policy making because spillovers force government to discriminate between sectors to incorporate externalities in policy making models. The paper also tries to explore the question of how little or how much to delegate the operation of an incentive policy from national to sub-national governments. It also raises the question about location aspects of incentives within a state’s borders.
[1] Investments in human capital and infrastructure have significant “public good” characteristics because of which market forces tend to produce sub-optimal level of investment in each. According to positive-sum game hypothesis Governments in order to attract FDI spend either directly (increased expenditure in supply of human capital and infrastructure) or indirectly (inducing private investment to generate supply) on human capital and infrastructure thereby bringing output further to optimum levels. This phenomenon may not have occurred in absence of such competition
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