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Globalization and South Asia: The Role of Foreign Direct Investment in Economic Development
Dushni Weerakoon Research Fellow
Institute of Policy Studies of Sri Lanka
Globalization and Foreign Direct Investment: The South Asian Experience
Globalization has seen significant developments in the world economy, creating greater
cohesion in international trade and finance and rapidly accelerating the integration of
developing countries into the global economy. However, these trends have not in any
sense been universally positive. For several reasons, the poorer economies have not
always seen benefits, and some of the richer developing countries have had a sharp
reminder of the potential adverse effects in the wake of the financial crisis in Southeast
Asia and more recent economic upheaval in Latin America.
South Asia as region was a relatively late comer to embrace ‘globalization’. South Asian
countries, that had very open economies in the immediate post-independence period in
the 1940s, had become some of the most highly protectionist in the world by the 1970s.
While this began to change gradually in the late 1970s, it was only in the 1990s that most
South Asian economies initiated substantive reform efforts involving both trade and
investment liberalization. Unilateral liberalization efforts were complemented by
multilateral efforts under the World Trade Organization (WTO) as well as regional trade
integration initiatives under the South Asian Association for Regional Cooperation
(SAARC).1
The major thrust of the liberalization effort in South Asia, and the most obvious
integration with the global economy, has been in the area of trade. While liberalization of
financial flows has taken place to some extent, most South Asian economies still retain
restrictions on the free flow of capital. Nevertheless, there is growing literature on the
1
nexus between trade and investment. Both theory and evidence suggest that measures that
reduce trade costs may provide an important stimulus not only to trade, but also to
foreign direct investment (FDI).2 Also, specific regional integration initiatives can
influence the level and pattern of FDI flows between member countries, as well as,
between member countries and outsiders. Economic integration can also affect the
absolute and relative growth rates in countries and thereby influence FDI that responds to
potential growth prospects of a region.
While it is increasingly recognized that trade and investment liberalization complement
each other, there is also concern about the economic role of FDI in developing countries.
This paper reports on an initial exploration of issues related to the role of FDI,
documenting the nature of intra-South Asian trade and investment flows, and presenting
the results of some preliminary investigations of the emerging trade and investment
linkages within South Asia. Section 2 will offer a brief review of the theory on linkages
between trade liberalization and investment flows. Section 3 will assess South Asia’s
increasing integration in the global economy and its attempts at regional economic
integration. Section 4 will present a more detailed examination of South Asia’s
experience with FDI, the sectoral distribution of such FDI and the role of regional
integration in promoting FDI in between South Asian countries. Section 5 will offer an
assessment of the (albeit limited) impact of FDI in South Asian economies, while section
6 concludes.
*********
2
Traditional models of trade in ‘goods’, assumed that factors of production such as labor
and capital were not internationally traded - i.e. not internationally ‘mobile’. In reality of
course factors are internationally mobile and have played a key role in shaping the global
economy. In recent years, with increasing liberalization of global capital movements (that
have facilitated a massive surge of global flows of both foreign direct and portfolio
investment), and in some instances, also of labor movements (as in the European Union),
there has been renewed interest in the theoretical and empirical analysis of the causes and
consequences of international factor mobility.
Early theoretical analyses of international factor mobility had two major strands. First,
trade theorists explored the implications of incorporating intermediate goods, and
international factor mobility in response to international factor price differences, in
standard trade models. Second, focussing on foreign direct investments undertaken by
firms, industrial organization theorists analysed the location choices of multinational
enterprises. This approach was pioneered by John Dunning (1977), who suggested that
firms undertake FDI when three factors are present, and the resulting advantages are
sufficient to offset the natural disadvantages of having to operate in a foreign country.
These are known as the ‘ownership, location and internalization’ (OLI) advantages. A
firm must have some product or technology that enables it to enjoy some market power in
a foreign market (‘ownership advantage’), the firm must see some advantage in
producing in the foreign location rather than at home (‘location advantage’), and there
must be some reason for it to want to exploit the ownership advantage internally, rather
than use a market based mechanism to gain payments for it (such as license or sell its
3
product or technology in the market for a fee). More recently, the blending of trade
theory and industrial organization in models that often explicitly incorporate scale
economies (‘New Trade Theory’) has stimulated the development of a number of
analytical models of the linkages between foreign trade and foreign investment (for a
review, see Markusen, 2000).
Differences in relative factor endowments - assumed to be exogenously given - are
central to explanations of international trade in models such as the Heckscher-Ohlin
model. One of the most celebrated ‘theorems’ associated with the Heckscher-Ohlin
model has been the ‘Factor Price Equalisation Theorem’, according to which sufficiently
similar economies will experience factor price equalization, even without free trade in
factors. In other words, trade in goods can ‘substitute’ for international factor movements
or trade in factors. By implication, greater international factor mobility can reduce
international trade, while trade liberalization, by encouraging greater trade in goods can
reduce incentives to trade in factors, including foreign investment flows. On the other
hand, other models, such as models that incorporate vertical inter-firm (backward or
forward) linkages, show that trade in goods complement trade in factors. If this were the
case, greater international factor mobility can enhance trade. Hence trade (foreign
investment) policy liberalization will have a positive effect on foreign investment (trade).
Considering the case of foreign direct investment and trade from the viewpoint of a
firm’s location choices, whether FDI and trade are complements or substitutes depends
on whether FDI is ‘horizontal’ or ‘vertical’. Horizontal FDI takes place when a
4
multinational enterprise (MNE) produces the same goods and services in multiple
countries, in order to avoid paying the ‘trade costs’ of exporting goods from one country
to another, but wishes to exploit its firm-specific advantages in production. With trade
liberalization, trade costs will come down, and the incentive to produce in multiple
country locations will diminish, particularly if there are significant economies of scale. In
this case FDI and trade are substitutes (see Markusen, 1984).3 Vertical FDI takes place
when a firm geographically fragments production by stages, in order to take advantage of
location-specific advantages such as lower factor prices in other countries. For example,
FDI and trade are complements if a MNE relocates part of its production chain, e.g. its
labor intensive assembly plant, to a low-wage country, and exports headquarter services
such as management skills, and intermediate inputs to that country, and then re-exports
final goods (Helpman, 1984). Imports of the ‘home’ country increase as it imports
products made by the foreign subsidiary, while its exports increase because the foreign
subsidiary requires capital and intermediate goods from home.
The theories of horizontal and vertical FDI developed side by side. Markusen et al (1996)
presented a unified theoretical framework incorporating both vertical and horizontal
FDI.4 In this framework, the type of FDI that emerge as a result of trade and investment
liberalization depends on various country characteristics. For example, if countries differ
significantly in relative factor endowments and, trade costs are low to moderate, then
vertical FDI dominates. On the other hand, when countries are similar in size and relative
endowments, and trade costs are moderate to high then horizontal FDI dominates. If a
country is small but skilled labor abundant, then vertical FDI is likely, and investment
5
liberalization can reverse the direction of trade because the country substitutes export of
(skilled labor intensive) services for the export of a good. The empirical literature on
whether FDI and trade are substitutes or complements has produced mixed results.5 This
is not surprising given the diverse motives that underlie international investment
decisions.
Though formal models that analyze the impact of RIAs on FDI, and on trade/investment
links are of relatively recent vintage and, in comparison with the case of trade, are in their
infancy, a considerable empirical literature has developed, analyzing in particular the
impact of integration initiatives in EU, and North America (NAFTA).6 Regional
integration typically reduces barriers to trade in goods as well as investment among
members; sometimes, as in the case of EU, it also reduces barriers to labor mobility. The
impact of regional integration arrangements (RIAs) on trade differ from those associated
with across the board reductions in barriers to trade, and have been analyzed in a large
literature that has followed the seminal work of Viner (1950).7 Available theory provides
no unambiguous predictions about the impact of RIAs, but likely outcomes associated
with a number of scenarios have been discussed.
RIAs can change the level and pattern of FDI, and thereby affect trade in ways that are
not fully captured in standard trade theoretic analyses of customs unions. Trade and
investment liberalization will change the location specific and firm-specific advantages.
RIAs, for example, can encourage geographical concentration: MNEs can restructure
their production bases to take advantage of reduced trade costs while exploiting scale
6
economies and agglomeration advantages. This may lead to FDI outflows from countries
that had earlier attracted ‘tariff hopping’ foreign firms to service protected domestic
markets because they can now be competitively supplied from production bases
elsewhere. On the other hand, better access to a larger market may attract FDI (from
within the region as well as from outside) to countries that have a strong locational
advantage. Such locational advantages may arise from availability of cheaper resources,
superior infrastructure, political stability, a more favorable policy regime, and a host of
other factors. Where firms have vertical linkages with other firms (as intermediate goods
suppliers or purchasers), reduced trade costs can lower the incentive to locate close to
these other firms; hence firm location may be more responsive to comparative factor
costs and advantages of being in similar industry clusters.8 Ethier (1998) has shown that
membership in RIAs can provide small but crucial competitive advantages to countries
that can help them attract large FDI inflows. Preferential treatment for RIA members can
generate not only the well known ‘trade creation’ and ‘trade diversion’ effects, but also
‘investment creation’ and ‘investment diversion’ effects. Economic integration can also
affect the absolute and relative growth rates in countries and thereby influence FDI that
responds to potential growth prospects of a region.
*********
In the limited sense of economic integration, globalization has been most manifest
through closer integration in trade in goods and services, movement of capital, and flow
of finances. And although the process of globalization has come to be viewed almost as a
recent phenomenon, it has been a historical process that has advanced and receded. From
7
the mid 19th century to the outbreak of World War 1, there was rapid global integration
through increased trade flows, movement of capital, and migration of people. The inter-
war period witnessed the erection of barriers to restrict free movement of goods and
services with the onset of the Great Depression. Whilst global integration resumed post-
1945, the nature and speed of integration accelerated with rapid advances in technology
in the last quarter of the 20th century.
Table 1
Openness of South Asian Economies
Applied Average Tariff 1995h 1999h 2000/01j
Trade Share of GDP (%)
Bangladesh 42.0a 22.2 22.0e 28.7 India 41.0 30.0d 32.3f 20.2 Maldives n.a. n.a. 20.8f 82.7 Nepal 11.0 16.3d n.a 44.7 Pakistan 51.0a 41.7b 20.4g 34.3 Sri Lanka 20.0 20.0c n.a. 77.5
Notes: a. refers to 1994; b. refers to 1996; c. refers to 1997; d. refers to 1998; e. refers to 1999/00; f. refers to 2001/02; g. refers to 2000/01. Source: (h) RIS, 2002, South Asia Development and Cooperation Report 2001/02; (i) WTO, Trade Policy Reviews (Reports of the Secretariat).
Though South Asia has often been seen as a region that has fiercely opposed integration
with the global economy, its experience through various stages of colonialism has been
otherwise. As Jayasuriya (2002) has pointed out, it was South Asia’s position in world
trade that initially attracted the Portuguese to the region in the 15th century. South Asia
was further exposed to 19th century ‘globalization’ under British colonial rule, which is in
part attributed to the rise of nationalist ideology in the sub-continent.9 Thus, while South
Asian countries by and large inherited relatively open ‘liberal’ economic regimes at the
8
time of independence, they moved to progressively more dirigiste economic regimes in
the 1950s and 1960s. Development thinking was dominated by an ideological
commitment to import substitution, the outcome of which was a shift towards erection of
barriers to international trade and capital.
As a result, by the 1970s, tariff and, even more importantly, non-tariff barriers (NTBs)
were extremely high, state interventions in economic activity had become pervasive,
attitudes to foreign investments were negative, often hostile, and stringent exchange
controls were in place. But this started to change in the late 1970s, largely as a result of
recurrent balance of payments crises, and relatively slow growth, particularly in
comparison to the high performing East Asian economies. In 1977, Sri Lanka initiated a
process of policy liberalization, and was in turn followed by other countries in the 1980s.
However, this was often a rather hesitant liberalization process, and was very uneven
across countries. It was from the early 1990s, with the start of a major reform process in
India that the region as a whole really started to liberalize. By the end of the decade,
though important policy barriers to trade and foreign investment remained, throughout
the region enormous progress had been made in this direction. However, even by the
mid-1990s, in a global comparison of import protection rates, South Asia remained a
highly protected region (Blackhurst et al., 1996). Thus, despite the policy reform process,
South Asia as a region still lags significantly behind in terms of its ‘openness’ to trade
with the rest of the world (Table 1).
9
Most South Asian economies saw a significant improvement in GDP growth in the 1980s
and 1990s compared to growth rates achieved in the previous two decades. However, the
link between growth and openness of an economy to global competitive forces, and
indirectly therefore to the process of globalization, remains contentious. While some have
drawn a direct causal relationship between superior growth performance during 1980-
2000 and the globalization period in South Asia (Bhalla, 2002), others point to the fact
that the most significant impetus of liberalization in South Asia came only in the 1990s
(Jayasuriya, 2002). The difference in performance in the two decades is quite marginal,
and therefore, does not fully support the argument that improved growth was a direct
result of integration with the global economy.
Table 2
GDP Growth Rates
% Share of Industry in GDP
Average1981-90
Average 1991-95
Average 1996-2000
1990 2000 World 3.4 2.8 3.9 Developing Countries 4.2 6.1 5.1 Developing Asia 6.9 8.8 6.4 Bangladesh 4.3 4.5 5.1 16 25 India 5.9 5.0 6.2 27 27 Nepal 4.8 4.7 4.6 14 20 Pakistan 6.0 5.1 3.3 26 23 Sri Lanka 4.3 5.4 5.0 25 27 Source: IMF, World Economic Outlook, (various issues); WB, World Development Report, (various issues). To ascertain the sustainability of longer-term growth that may be correlated with
liberalization programs requires longer data-periods than available in the context of the
South Asian experience. Sustainability is country-specific, defining the timing,
10
sequencing and pacing of reforms. Thus, the reform process would differ between a
country that had a more ‘liberal’ economic policy regime in comparison to one that was
more ‘closed’ to begin with. Regionally, the reform process in South Asia has been more
gradual and hesitant in comparison, for example, with countries of the Southeast Asian
region. This has been more obvious in South Asia’s reluctance to integrate its financial
markets, and its continuing use of controls on the free flow of capital. In the aftermath of
the East Asian financial crises, most South Asian economies considered their stance to be
vindicated, as the contagion effect of the crisis took hold. The perceived adverse impact
of ‘globalization’ has to some extent reinforced a gradualist approach to further
liberalization of capital flows in the region.
*********
The unilateral trade liberalization process in South Asia also encompassed attempts at
regional trade integration under the framework of SAARC.10 This was partly a response
to the unprecedented resurgence in establishing RIAs on a global scale in the early 1990s.
A common argument put forward is that that the protracted nature of negotiations under
the Uruguay Round (UR) encouraged countries to look to regional partners as an
alternative means of pushing ahead with a reform agenda. The United States in particular
– long opposed to regionalism – initiated discussions on a North American Free Trade
Agreement (NAFTA) in the face of seeming intransigence on the part of the European
Community (EU) to arrive at an agreement on agriculture under the UR. However, even
with the successful conclusion of the UR in 1993, interest in regionalism did not wane. In
11
fact, the enthusiasm for expanding and deepening levels of integration has grown in most
regional groupings. This appears to suggest that the ‘second wave’ of regionalism has
been driven by compulsions of globalization. With heightened global competition, access
to enlarged markets and sources of capital become vital elements for economic
development and is a driving factor behind renewed interest in regional integration.
Table 3 SAPTA Preferences: SAPTA 1-3a
Granted to
LDCs Only Granted to All
Countries Total
Bangladesh 144 407 521 Bhutan 124 109 233 India 2082 472 2554 Maldives 6 172 178 Nepal 163 328 491 Pakistan 229 262 491 Sri Lanka 44 155 199 SAARC 2762 1095 4667
Notes: a. Inclusive of concessions granted under all three rounds of negotiations at the 6-digit HS code level. Source: Compiled from the Consolidated National Schedule of Concessions of Member States.
The emergence of new RIAs in North America and Latin America and the expansion of
existing ones in Europe and East Asia saw the increasing marginalization of South Asia
as a region in the global economy. For South Asian countries, in the absence of an entry
point into one or more of these more dynamic regional bodies, the next best option
appeared to be to cooperate amongst themselves in the hope that it would generate
economic benefits in the medium to longer term. The decision to proceed on economic
cooperation culminated in the implementation of a South Asian Preferential Trade
12
Agreement (SAPTA) in December 1995. In 1996, member states agreed in principle to
go a step further and attempt to enact a South Asian Free Trade Agreement (SAFTA).
While the timeframe for the establishment of SAFTA has suffered setbacks with the ebb
and flow of political tension in the region, the target date is likely to be 2008 after the
expected ratification of the Treaty in 2004.
Trade liberalization under the SAPTA process has so far encompassed three rounds of
negotiations. The first round of concessions came into effect in December 1995 where
tariff concessions were exchanged on a total of 226 products under the HS Code system
on a product-by-product basis.11 The second round also adopted the same negotiating
method and was completed in November 1996 with the exchange of concessions on
additional 1900 products. The third round of negotiations was completed in November
1998, combining both a product-by-product and chapter wise approach to include further
concessions on nearly 2500 tariff lines at 6-digit level of aggregation. With the
conclusion of the third round, nearly 4700 tariff lines out of a total of 6000 have been
covered by preferential access (Table 3). India has offered the largest number of
concessions followed by Bangladesh, Pakistan and Nepal. The LDC member states
within SAARC have also been offered a larger share of such concessions vis-à-vis the
non-LDC states.12
SAPTA to date has had no significant impact in changing the existing trade patterns in
South Asia (Table 4). Intra-SAARC trade remains a tiny fraction of total trade of the
region, being constrained not only by political and policy factors, but also by underlying
13
similarity of the economies that limits comparative advantage driven trade. SAPTA has
had a limited impact for a number of reasons: the product-by-product approach has failed
to produce any significant result as the emphasis was on the number of tariff items
negotiated rather than on the amount of trade liberalized; the negotiated products
included have been largely irrelevant to each others trading interests in the region; the
depth of tariff cuts have been marginal; the rules of origin (ROO) requirements also act
as an inhibiting factor; and, non-tariff barriers have further eroded the effectiveness of
tariff preferences granted (Weerakoon and Wijayasiri, 2002).
Table 4
Intra-SAARC Tradea
Intra-SAARC trade
(US $ mn) World trade of
SAARC countries (US $ mn)
Share of intra-SAARC trade in world trade of SAARC countries (%)
1980 1210 37885 3.2 1985 1054 44041 2.4 1990 1584 65041 2.4 1995 4228 104159 4.1 2000 5884 141978 4.1 2001 6537 139585 4.7
Notes: a. Data for Bhutan not available. Source: IMF, Direction of Trade Statistics, various issues.
The fact that countries share some basic similarities (low income, relatively labor
abundant, comparative advantage in similar commodities, dependence on markets outside
the region for their exports) reduce the potential for comparative advantage driven trade.
The economies are mostly agricultural based with a small industrial sector,
manufacturing only a narrow range of goods (with the exception of India). While trade
complementarities in other regions have grown on the basis of manufactured goods, this
14
has not taken place in South Asia due to the small size of the manufacturing sector and
the limited range of goods produced. The low volume of intra-regional trade that is taking
place is based largely on agricultural products, which are produced in some countries and
not in others. Therefore, although SAARC countries have diversified their exports, they
are still geared to markets outside the region, where they compete with one another’s
products.13 Low growth and demand in the region itself, abetted by historical trade links
with the developed countries have resulted in extra-regional trade patterns. The low per
capita income level also constrains potential for intra-industry trade, generally associated
with higher income countries.
It should be noted here that regional cooperation initiatives providing preferential
treatment to members has been largely confined to trade, and have not extended to
investment. Increasingly, however, trade flows have become corollary to investment
flows and there is evidence to suggest that the potential for expanding intra-SAARC
economic links, in both trade and investment, is not entirely absent.14 There are important
structural changes in intra-regional trade that may be important indicators of future
trends. Textile, and machinery and equipment have become increasingly more important
in intra-regional trade and a larger proportion of exports going into the region is now
manufactured products, while in the past, it was primary products (Jayasuriya and
Weerakoon, 2001). This shift into manufactured product trade, associated with the higher
level of industrialization of the region, opens up opportunities for scale economies and
intra-industry trade (complemented by investment flows) to play an increasing role.
15
4. Globalization and Liberalization: FDI in South Asia
The assimilation of emerging capital markets into the global market experienced fresh
momentum in the mid 1980s. This was helped by liberalization of domestic capital
markets as well as developments in industrial economies.15 The increase in capital flows
included those of a short-term, and therefore more volatile nature (portfolio investment),
as well as those of a more stable nature (FDI).16 With the progressive adoption of export
oriented policies in South Asia, the need for technological and managerial skills transfers
which are typically associated with FDI, dictated the need for investment liberalization.
Thus, a range of measures were implemented to enhance their attractiveness to potential
Table 5
Foreign Direct Investment Inflows (US$)
1984-1989
1990-1995 1996 1997 1998 1999 2000 2001
World (bn) 115 225 386 478 694 1088 1492 735Developing Countries (bn) 22 74 153 191 188 225 234 204Developing Asia (bn) 12 47 93 105 96 103 134 102 South Asia (mn) 310 1221 3618 4938 3560 3093 3095 4069 Bangladesh 1 6 14 139 190 178 280 78 India 133 703 2525 3619 2633 2168 2319 3403 Maldives 3 7 9 11 12 12 13 12 Nepal 1 6 19 23 12 4 0 19 Pakistan 136 389 918 713 507 530 305 385 Sri Lanka 36 110 133 433 206 201 178 172
Source: UNCTAD, World Investment Report, various years.
foreign investors. These include provision of various tax, duty and other incentives,
removal of restrictions on repatriation of profits, establishing current account
convertibility, reduction of number of prohibited or restricted sectors, relaxation of
16
ownership restrictions, non-discrimination in favor of domestic investors, fast tracking of
FDI approvals, guarantees against nationalization and expropriation, and the setting in
place of internationally acceptable dispute resolution mechanisms.
Trends in FDI inflows reflect the fact that until recently, most countries in South Asia
were not seen by international investors as attractive investment destinations and, in any
case did not welcome foreign investments. Hence, until the 1990s, FDI flows were quite
minimal. FDI flows to South Asia started to pick up in the mid-1990s largely as a result
of progressive liberalization of FDI policies in most of the countries in the region (Table
5), and the adoption of generally more outward oriented policies.17
South Asia improved its share in terms of total FDI inflows to the world, developing
countries and Asia over the period 1985-1997 (Table 6). In the aftermath of the East
Asian financial crisis, the proportion of FDI flows to the region has declined, reflecting a
general slowdown in capital flows to the Asian region. In the latter part of the 1990s,
increased cross-border merger and acquisition activity saw a redirection of global FDI
inflows to developed regions of the world. The share of FDI to developing Asian
economies declined from 24.2 per cent in 1996 to 9 per cent in 2000. Notwithstanding
this trend, the magnitude of inflows attracted by the South Asian region remains
relatively meagre. In 2001, it was only US $ 4 billion, a mere 0.6 per cent of global
flows. In contrast, China received more than 47 billion of all global inflows. Within the
South Asian region, India has increasingly accounted for the bulk of FDI inflows (Table
17
5). Its share has increased progressively from 40 per cent in the mid 1980s to over 80 per
cent by 2001.
Table 6 Share of FDI Inflows
Share of FDI Inflows (%) 1984-1989
1990-1995 1996 1997 1998 1999 2000 2001
Developing Countries 19.2 33.0 39.5 40.0 27.0 20.7 15.9 27.9Developing Asia 10.0 21.0 24.2 22.1 13.8 9.4 9.0 13.9Share of South Asia (%) World 0.3 0.5 0.9 1.0 0.5 0.3 0.2 0.6Developing Countries 1.4 1.6 2.4 2.6 1.9 1.4 1.3 2.0Developing Asia 2.7 2.6 3.9 4.7 3.7 3.0 2.3 4.0
Source: UNCTAD, World Investment Report, various years.
Despite this growth, FDI as a proportion of the GDP of South Asian countries remains
very low. For example, in the mid-1990s, the share of FDI in GDP for most of the South
Asian Economies was in the region of approximately 1 per cent (Table 7). During the
same period, Malaysia was attracting FDI equivalent to over 6 per cent of its GDP, whilst
the corresponding figure for China was approximately 5 per cent of its GDP. By the same
token, FDI has played a muted role in total fixed capital formation in South Asia
compared to the experience of East Asian economies.
Disincentives created by the policy regimes is arguably the primary factor explaining the
poor performance of South Asia compared with countries in East Asia in attracting FDI
inflows. The protectionist trade policies with their inherent anti-export bias was not
conducive to attracting export oriented FDI, and this was exacerbated by the many direct
and indirect regulatory barriers that raised the costs of investment to foreign firms.
18
Further, where the domestic market may have been considered large enough to have
attracted ‘tariff hopping’ type FDI to service the domestic market – as may have been the
Table 7 Contribution of FDI Inflows
FDI Inflows as % of GDP FDI Inflows as % of GFCFa
South Asia 1990 1995 2000 1990 1995 2000 Bangladesh 0.01 0.01 0.67 0.1 0.0 2.9 India 0.05 0.63 0.54 0.2 2.6 2.4 Maldives 2.81 1.75 2.32 7.6 5.6 8.9 Nepal 0.18 0.20 0.00 1.1 0.9 0.0 Pakistan 0.62 1.32 0.56 3.6 7.7 4.0 Sri Lanka 0.54 0.53 1.17 2.5 2.1 4.2 East Asia China 0.99 5.10 3.77 3.8 14.7 11.3 Malaysia 5.29 6.65 4.21 16.0 15.2 16.4 Philippines 1.38 2.01 1.88 6.0 9.0 10.4 Thailand 2.83 1.21 2.48 7.0 2.9 11.2 Vietnam 0.31 11.24 4.24 2.4 45.4 15.4
Notes: a. Gross Fixed Capital Formation. Source: UNCTAD, World Investment Report, (various years); IMF, International Financial Statistics, (various years).
case in India – the disincentives arising from regulatory barriers were further
strengthened by the perception that governments and other powerful political forces were
often, if not downright hostile to FDI. It is noteworthy, however, that assessments of the
general climate for foreign investment, indicated, at most, only relatively minor
differences between China and South Asian countries (Naya and Iboshi, 1999; Johnson,
Holmes and Kirkpatrick, 1998). Given the huge difference between China and South
Asian countries as destinations for inward FDI flows, this is perhaps an indication of the
key importance of trade policies and other factors. Among the latter, political instability
and the implied policy instability may have inhibited FDI to a significant degree. The
19
strong positive response of FDI flows to trade and investment liberalization in Sri Lanka
in the early 1990s that tapered off with the subsequent escalation of political instability is
consistent with this explanation (see the discussion of this issue in Athukorala and
Rajapatirana, 2000). Further, poorly developed infrastructure facilities put South Asia at a
disadvantage relative to the East Asian countries who had already embarked on extensive
expansion and modernization of their infrastructure facilities, while (with the exception
of Sri Lanka) the generally low levels of literacy and investments in human capital may
also have deterred foreign investors.
Table 6
Sectoral Pattern of FDI in South Asia Textiles &
Garments Infrastructure Basic
Engineering Services Mining &
Quarrying Chemicals &
Pharmaceuticals Bangladesh 27.9 8.6 5.2 10.4 8.7 India 1.5 56.4 14.5 9.9 6.5 Pakistan 0.2 39.1 3.7 15.7 13.6 Sri Lanka 16.6 57.2 6.2 Source: Jayasuriya and Weerakoon, 2001.
The sectors that have attracted most FDI vary between countries in South Asia (Table 6).
The textiles and garments sector – with garments being produced primarily for export –
has attracted a high proportion of FDI into Bangladesh (28 per cent) and Sri Lanka (16.6
per cent). In the case of India, infrastructure (including public utilities) has attracted the
bulk (56 per cent) of approved FDI, while in Pakistan, the power sector alone accounts
for nearly 40 percent of approved investments. In many countries, the public utilities,
such as telecommunications and gas, have received significant FDI, driven by the trend
towards privatization of public utilities and other state owned economic enterprises.
20
While FDI inflows have been attracted to export oriented industries that exploit
comparative advantage in labor and specific natural resources, South Asia has also
attracted home market oriented industries that supply goods and services that are
constrained primarily by high transport costs. This type of investment is different to the
tariff-hopping FDI that was attracted when markets for potentially importable products
were protected (and were expected to be protected in the longer run). Thus, investment
liberalization has attracted some FDI that competes with home-based firms in market
segments, such as the market in soft drinks and fast food.
Table 7
Share in FDI Stocks in South Asia by Geographical Origin during 1990s Bangladesh India Nepal Pakistan Sri Lanka Developed Countries 48.4 85.6 44.2 64.9 33.5 US 20.6 24.1 17.4 18.1 5.2 Western Europe 18.4 45.9 13.3 24.2 13.4 Japan 8.8 7.6 5.1 9.3 6.3 Developing Asia 51.4 4.0 54.0 24.6 55.8 China 1.2 3.4 0.2 28.5 Hong Kong 8.9 0.9 4.2 1.2 2.3 Singapore 5.5 2.1 2.5 2.7 5.0 South Korea 3.0 1.0 3.4 5.7 6.6 South Asia 4.9 … 36.9 0.2 4.8 India 3.5 36.7 0.1 1.9 Pakistan 0.9 0.2 Sri Lanka 0.5 Source: RIS, South Asia Development & Cooperation Report 2001/02.
FDI to the region is predominantly from outside the region and strongly reflects the
sectors into which they have been attracted (Table 7). For example, in the case of Sri
Lanka and Bangladesh, much of the FDI has originated from Southeast Asia into the
21
textiles and garments sector to take advantage of quotas allocated under the Multi Fibre
Agreement (MFA). Similarly, countries such as India and Pakistan have seen a larger role
played by FDI from North America and Western Europe in sectors such as infrastructure.
The data is not adequate to determine accurately the degree to which non-infrastructure
related investments outside the textile and garments sectors are export oriented or home-
market oriented, but there are indications that significant amounts of FDI are coming in
to exploit the low labor cost advantages of South Asia, and to utilize them as export
platforms. To the extent that import protection is coming down, the tariff hopping motive
that attracts home market oriented investments weakens. On the other hand, the
increasingly more FDI friendly environment and the perception of improved growth
prospects following more liberal policies may make even some types of home market
oriented investments more attractive, even though with a more liberal trade regime,
import competition will be more intense and servicing the market from abroad may be
less difficult. Where economic prospects have dimmed because of political factors, and
confidence in institutions and broader economic management weakens, as is the case in
Pakistan and Sri Lanka, their attractiveness as investment destinations falls despite the
existence of a favorable policy regime.
While FDI from outside is far more important than intra-regional investments in most
countries (with Nepal, where Indian investments dominate, a conspicuous exception),
there are signs that intra-regional investments are increasing. The major outward FDI
flows are from Indian firms, who have started to expand FDI both within the SAARC
22
region (Bangladesh, Maldives, Nepal and Sri Lanka) and outside, particularly after the
Government of India liberalized its policy governing Indian overseas investments in the
early 1990s. Of course there have been Indian companies with considerable involvement
in joint ventures in neighboring countries, such as Sri Lanka and Nepal even as far back
as 1970s. In addition, there may have been considerable unrecorded outward FDI
undertaken through long established family-linked firms operating in these countries.
Recent estimates appear to suggest that not only are such investments on the rise, but that
firms from other SAARC member countries are also increasingly undertaking FDI within
the region, and investing in a range of sectors and activities (Jayasuriya and Weerakoon,
2001).
Investment from South Asia accounted for nearly 5 per cent of total FDI in Bangladesh of
which Indian invested alone stood at 3.5 per cent (Table 7). Indian investment is found to
be concentrated in services (33 per cent), fabricated metal products, machinery and
transport equipment (34 per cent) – primarily in steel manufacturing - and chemical,
petroleum, rubber and plastic products (18 per cent).18 Services sector investments
included software development, data entry and processing, hospitals and clinics, cold
storage, and hotels. Pakistan has investments in a range of non-metallic mineral products
(glass, cement, marble and stone products), and in food, beverages, and tobacco. Sri
Lankan firms had 11 ventures, mostly in services, including leasing, hospital, hotel and
restaurant, and shipping.
23
In India, despite its huge internal market, investments from the SAARC region have been
quite insignificant, both in relative and absolute terms, accounting for less than 1 per cent
of total foreign investment in India. Bangladesh is the largest investor from the region,
followed by Sri Lanka, Nepal and Maldives. The one SAARC country where regional
investment dominates in total FDI is Nepal where India is the single largest investor. On
the other hand, none of the SAARC countries register as significant investors in Pakistan
though available data indicate that there is some (albeit very limited) flow of FDI from
the regional economies.
In Sri Lanka, India is the largest investor among the SAARC countries, followed by
Pakistan and Maldives. (Sri Lankan firms, in turn, have also invested in Maldives.)
Indian investments are mainly in food, beverage and tobacco products (78 per cent);
chemical, petroleum, rubber and plastic products (13 per cent); and services (7 per cent).
Indian firms are active in the hotel and restaurant sector, as well as in the tea plantation
sector. Much of the investment from Pakistan are in textile, wearing apparel and leather
products category, while two of the three projects funded by firms from Maldives are in
services.
Regional integration can also attract FDI from outside the region to take advantage of
reduced trade costs and access to a larger market. However, there is little evidence of
such flows to South Asia at present. This is partly because the liberalization process is
proceeding in all countries in the region, even though there are still differences in the
levels of protection at present. As such, relatively little FDI can be drawn in to a country
24
with the aim of servicing another market, using opportunities to exploit regional trade
preferences. Moreover, trade integration has so far been very limited in South Asia. Thus,
for countries like Sri Lanka, the opportunity to attract outside FDI to supply, say the
Indian market, is now considerably diminished. (Of course this may still occur if the
partner country has some intrinsic comparative advantage and the foreign firm has some
firm-specific asset that it does not want to market directly.)
With the anticipated move to a free trade area, and with reduced intra-regional trade
costs, scale economies will play an increasingly more important role, and production will
get more concentrated in regional locations to maximize use of location specific assets
(comparative advantage). This means that there may be some substitution of trade for
FDI, as some earlier established foreign subsidiaries contract or close down and that
market is supplied from elsewhere. Thus, we can expect that horizontal FDI will occur
only where proximity to the market is at a premium. Of course horizontal FDI will
continue to occur – and may even be enhanced - in industries such as tourist resorts and
hotels, where the primary service has to be supplied in situ with network benefits being
internalized within the multinational. To the extent that regional links strengthen, firms
from within the region will have a competitive edge in servicing these markets (compared
with outsiders) because of their established positions within the national markets.
*********
25
Globalization has economic, political and cultural impacts, the effects of which, it is
argued, may be particularly powerful in culturally heterogeneous societies divided along
lines of identity such as language, religion, ethnicity, caste, class, etc. (Barker, 1999).
South Asia, with its complex economic and political history, with the world’s largest
concentration of the poor, and a high degree of political volatility, is particularly
vulnerable to charges of inequities of globalization. The rest of this section will look
primarily at available evidence on the economic impact of FDI in South Asia. Given the
limited volume of FDI inflows to the region, the evidence at best remains fairly sketchy.
FDI is argued to contribute to growth in developing countries by creating employment,
increasing exports, and introducing new management and production techniques. There is
certainly country evidence to support some of these arguments. Existing empirical
literature on Sri Lanka’s experience with FDI appears to offer support to the hypothesis
that FDI can be more efficient in raising manufactured export growth (Athukorala, 1995,
1998; Athukorala and Jayasuriya, 2000). And a recent study by Agarwal (2000) has
found evidence that FDI has had a strong complementary effect on investment in South
Asia, leading to additional investment by host country investors. But, by and large, the
evidence remains mixed. Other studies that have assessed whether FDI increases
aggregate investment in developing countries (including India) have argued that FDI
inflows seem to have a negative effect on domestic investment (Fry, 1995; Dhar and Roy,
1996).
26
Agarwal (2000) also finds that FDI inflows have helped South Asian countries to achieve
faster economic growth, beginning in the 1980s and especially over the 1990s.19
Chakraborty and Basu (2002) also find FDI to be positively related to growth in the case
of India. However, the evidence, by and large, remains unclear. Other studies suggest that
the relationship between FDI and growth depends on country specific factors and no
simple conclusions can be drawn (de Mello (1997). Even if a positive correlation is
found, the issue of causality remains unresolved. It could well be that FDI increases
growth, but also that the prospect of higher growth attracts FDI. For the most part, the
evidence that FDI contributes to growth is encouraging rather than compelling (see
Lensink and Morissey, 2001).
While FDI may contribute to growth in developing countries, benefits also may not
always be equally distributed. The distribution of gains from FDI is also linked to some
degree to the sectors in which FDI is directed. FDI inflows to relatively capital intensive
and skill-intensive manufacturing sectors will have a different employment and income
impact than on FDI flowing to labor intensive and unskilled manufacturing. Similarly,
FDI into financial services is also more likely to be associated with high skill intensive
employment and income. Thus, FDI may have an uneven distributional impact within
economies as well as between countries and regions. Recent evidence from five East
Asian economies and five African economies suggest that foreign-owned firms tend to
pay higher wages, but skilled workers tend to benefit more than less-skilled workers
(Velde and Morrissey, 2001, 2002).
27
Systematic evidence on the effects of FDI in South Asian economies is lacking. In the
case of both Sri Lanka and Bangladesh, vertical FDI has been the dominant source to take
advantage of an abundant source of relatively cheap labor. The leading sector which has
attracted FDI has been the textiles and garments sector, employing typically unskilled
female labor. In Sri Lanka, the garments sector has come to dominate manufacturing in
the post-liberalization period, accounting for over 50 per cent of total export earnings for
the country. In addition, it provides employment to over 5 per cent of the total labor force
(and one-third of total manufacturing sector labor employment). Of this, 87 per cent of
employment in the garment sector is female, and they account for 90 per cent of
relatively unskilled machine operator jobs (Kelegama and Epaarachchi, 2002).20 Thus,
the garment industry, driven by inward FDI was a significant source of new employment
opportunities for young female labor. Conversely, liberalization also had a severe impact
on the domestic textile sector with a significant corresponding loss of employment. Prior
to liberalization, the domestic textile industry is estimated to have employed 150,000, but
this figure had fallen to 25,000 by the end of the 1980s (Ministry of Handloom and
Textiles, 1991). Thus, while new employment opportunities were created, this was
accompanied by significant displacement of employment in import competing industries.
There is little technology transfer associated with FDI inflows into the garments sectors,
albeit with the possibility of some degree of managerial skills transfer. FDI inflows into
more skill intensive industries such as the manufacture of automobiles and consumer
goods can bring in new technology. If such foreign firms are more capital intensive,
employment levels may fall in the short-term, but in the longer term technology driven
28
productivity enhancement may confer wider benefits to the host economy. Nevertheless,
evidence from India finds that FDI inflows are found to be labor displacing. The
technology transfer brought in by FDI is found to cause an excess supply of labor, creating
downward pressure on unit labor costs (Chakraborty and Basu, 2002). While the
international evidence on the nature and extent of technology transfer from foreign to
domestic firms is mixed, evidence from India again points to some positive spillovers.21
India has seen a relatively higher share of FDI going into technology intensive sectors
such as basic engineering and chemicals and pharmaceutical sectors than most other
South Asian economies (see Table 6).
If FDI inflows represent additional investment, it should provide employment. However,
increasingly FDI inflows are for mergers and acquisitions, attracted by the trend towards
privatization of public utilities and other state owned economic enterprises. Such FDI
inflows may not necessarily increase employment. In the case of India, for example, there
is evidence to suggest that multinational corporations have been notably active in
acquisitions, accounting for nearly a third of all corporate acquisitions during the period
1991-97 (Basant, 2000). Such FDI inflows can also lead to increasing market
concentration in some sectors.22 Similarly, in Sri Lanka, privatization of state owned
enterprises have seen monopoly status being conferred on multinationals for an agreed
period of time as an additional inducement to attract such investors. For example, a large
multinational (Shell Overseas) was granted a monopoly status for a five year period with
the privatization of Sri Lanka’s state owned gas company. Such deals have often been
driven by the need to attract greater inflows of FDI for domestic fiscal purposes rather
29
than imperatives associated with improving efficiency. Lack of transparency in such
negotiations (for example, as in the case of Enron in India) have perpetuated a degree of
unease and contributed towards instilling a negative perception of multinational driven
FDI in some quarters of South Asian society, reinforcing historical hostility to foreign
investment. Such sentiments in turn have been transferred to the whole concept of
‘globalization’ and its resultant impact on host economies.
Concerns with globalization have been reinforced with developments in the multilateral
agenda on future trade negotiations. With more and more countries adopting liberal
economic policies and integrating with the global economy, South Asian economies too
have to compete more fiercely for foreign investment. As more countries progressively
liberalize their trade regime, in the expectation that more FDI will follow, ‘new issues’
linking trade and FDI flows are being thrust on developing countries. Increasingly,
environmental, health and labor standards are coming on to the multilateral agenda under
the WTO, with the caveat that free trade should involve a ‘level playing field’ by
harmonizing domestic policies across countries in these areas. Harmonized standards are
encouraged on the grounds that FDI will move to countries that maintain low standards
on environment, labor, etc. While there is no defensible evidence to support such
arguments, the linking of labor standards to FDI and trade have compelled some South
Asian economies (for example, the carpet industry in Nepal) to adopt international
guidelines. Similarly, in Sri Lanka, increasingly FDI in the garments industry is also
being linked to the welfare of workers. Often, inspection teams are sent to examine and
report on the working conditions of factory workers prior to the placement of orders.
30
Thus, FDI may also contribute ‘positively’ to improved welfare of labor, as long as such
measures are not used as protectionist tools to restrict market access of developing
country exports.
While there has been a general acceptance of the positive and desirable nature of FDI in
South Asia, pockets of resistance to foreign investment and ‘globalization’ continue to be
heard, spurred by the lack of transparency and perceived corruption in some major
projects involving FDI (such as the case of Enron in India’s power sector). The
transformation of the information-entertainment industry in most South Asian countries
with the infusion of FDI has also generated concern over the ‘westernization’ of cultures
in the region. Nevertheless, it would be difficult to argue convincingly that South Asia –
which remains one of the poorest regions of the world – constrained by inadequate
domestic financial resources, is likely to be better off without participating actively in the
global economy. The issue that confronts the region is how to exploit opportunities of
globalization – in this instance, increased access to FDI – while ensuring that its gains are
equitably distributed.
*********
The relative paucity of FDI inflows to South Asia in the past is not difficult to fathom,
given the inward looking policies and the relatively inhospitable environments for inward
FDI. In recent times, the liberalization process in the region has infused a dynamism to
the region’s economies in several ways. Economies are becoming more open, outward
oriented, and more receptive to foreign investment and trade; at the same time, many
31
business firms are expanding their horizons, and are not only entering into joint ventures
and other partnerships with foreign firms but are also taking the initiative to undertake
FDI in other countries. The degree to which FDI from outside has been attracted to the
region has been primarily affected by the overall liberalization policies – in particular the
degree to which trade liberalization has been accompanied by domestic market reforms,
the liberalization of FDI regulations and the development of a more FDI friendly policy
stance – and the growth dynamics of the individual countries.
Though the extent of FDI links in South Asian economies are still rather limited,
increased inflows (both from outside and within the region) indicate the potential and the
manner in which future developments will occur in a more liberal trading and investment
environment in South Asia. At present, the relatively limited progress with preferential
liberalization within the SAPTA framework obviously limits the extent to which regional
FDI flows will be stimulated. Larger outside FDI flows will require substantially greater
progress with the overall trade and investment regulation process, complementary
domestic market and institutional reforms and expansion and modernization of
infrastructure facilities. Though short term adjustment costs are obviously important, and
must be taken into account in introducing policy changes, it seems also clear that in order
to achieve sustained and high growth, South Asia must open up and exploit growth
opportunities.
Nevertheless, keeping in mind the political volatility of the region, FDI policies should be
geared to those that increase the potential for employment and for wider benefits to the
32
economy from transfer of technology, improved productivity and growth. Domestic firms
should be encouraged to increase efficiency in order to benefit from linkages with and
spillovers from foreign firms. Ensuring a fair distribution of the gains from FDI will be
critical in building mass support, not only for the domestic liberalization agenda but also
for integration with the global economy. It is clear that South Asia cannot afford to step
back from the process of globalization. The challenge will be to ensure that the general
thrust of liberalization fosters more efficient, gainful and sustainable trade-investment
links that contributes to overall growth while ensuring that other social objectives, such
as reducing inequities and levels of poverty, are not undermined.
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1 SAARC was established in 1985 by Bangladesh, Bhutan, India, Nepal, Maldives, Pakistan, and Sri Lanka.
35
2 FDI is conventionally defined as a form of international inter-firm cooperation that involves a significant equity stake in, or effective management control of foreign firms (de Mello, 1997: 4). These differ from ‘portfolio investments’ – purchases by foreigners of bonds, stocks and other financial market instruments - primarily in terms of the degree to which such investments provide the potential for managerial control. 3 See Caves (1996) for a discussion of the factors that influence an MNE’s trade and investment decisions. (‘Trade costs’ include all costs that are incurred in conducting international trade and include transport costs, tariffs, and other transactions costs). 3 See also, Markusen (2000) and Markusen and Venebales (1998). 4 See also, Markusen (2000) and Markusen and Venebales (1998). 5 There are many empirical studies that explore the links between trade and investment (eg. Lipsey and Weiss, 1981 and 1984; Blomström et al., 1988;, Ekholm, 1998; Pain and Wakelin, 1998). 6 See Ethier (1998) for a formal discussion, and also Ozawa (1992). 7 The concepts of ‘trade diversion’ and ‘trade creation’ are associated with the preferential and discriminatory nature of trade liberalization in RIAs, so that trade is encouraged among members, sometimes at the expense of non-members. For a survey, see Hine (1994). 8 See Amiti (1998) for a discussion of these issues. 9 For example, Jayasuriya (2002) argues that opening up the economies to the world economy was viewed as a mechanism for the exploitation of the colonial nations by a growing South Asian nationalist ideology. 10 Although the SAARC Charter included economic cooperation in its agenda, it was only in the late 1980s that explicit attention was paid to formulating a policy framework to initiate the process. 11 This entails an exchange of 'offer' and 'request' lists of goods on a bilateral basis where the results are later multilateralized. 12 Bangladesh, Bhutan, the Maldives and Nepal are considered LDC member states within SAARC. 13 For example, garments form the largest single export of Bangladesh, Sri Lanka and Nepal, and it is a major export category of India, Pakistan and the Maldives. 14 See Mukherji (1998) for a study of trade and investment links between India and Nepal, and Mukherji (2000) for a study of trade and investment linkages between India and Sri Lanka. See also Jayasuriya and Weerakoon (2001) for a more detailed assessment of potential trade-investment nexus in South Asia. 15 The latter include regulatory changes in the US and other financial centers in the late 1980s that resulted in increasing amounts of capital being managed by institutional investors. In addition, the revaluation of the Japanese yen in the mid 1980s saw a surge of outward capital from Japan as well. 16 It is practically impossible to gauge whether capital flows are of a temporary or permanent nature. The distinction is, however, of importance to policy makers in order to identify the potential vulnerability of an economy to reversals and hence be in a better position to take corrective measures. The possibility of volatility and reversibility seem to depend on the type of inflows. Foreign direct investment (FDI) that comes in the form of finance flows is no different from portfolio investment. However, if it comes in the form
36
of import surplus -- that is, in terms of machinery and capital -- it is likely to be of a much more stable nature (Griffith-Jones et al., 1997). 17 There are major problems with the available FDI figures for the SAARC countries. Often the data available is for approvals, but not for realized investments. Annual data are often cumulated with no adjustments for changes in purchasing power. There are sometimes wide discrepancies between national and international data sources, and among national sources themselves. Hence the data given here should be treated with considerable caution. 18 See Jayasuriya and Weerakoon (2001) for details. 19 The impact of FDI inflows on GDP growth was found to be negative prior to 1980. This is argued to be because FDI inflows may have earned excessive profits and led to immiserizing growth when there were severe trade and financial markets distortions in most South Asian economies. 20 It has been estimated that at the end of the 1990s, the garment industry in Bangaldesh provided total employment to approximately 1.5 million, of whom 1.2 million were women (Rahman, 1998). 21 See Basant and Fikker (1996) and Kathuria (1998) quoted in Athreye and Kapur (2001). 22 One of the largest multinationals in India, Hindustan Lever (a subsidiary of Unilever) acquired Tata Oils (its principal rival in oil in India), Brooke Bond Lipton (India’s largest company in food and beverages), Pond’s India (cosmetics), Kwality, and Milkfood (processed foods) in a series of mergers and acquisitions after 1992 (Athreye and Kapur, 2000).
37
Dushni Weerakoon has a BSc in Economics with First Class Honors from the Queen’s University of Belfast, Northern Ireland, UK. Has a Masters and PhD in Economics from the University of Manchester, UK. Currently a Research Fellow of the Institute of Policy Studies of Sri Lanka. Research interests include trade policy and regional integration and macroeconomic policy management.
38