Attracting FDI.docx

8/18/2019 Attracting FDI.docx

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Introduction

Like many developing countries, countries in South Asia are experiencing a

youth bulge entering the labor market. To absorb these workers ( million per

month !or the next "# years in the case o! South Asia$, provide higher living

standards and reduce poverty, these economies will have to rely on more than

%ust public investment. It’s just not feasible to provide all the economic capacity

for more and better jobs through the government sector at a time when budgetsare already under pressure and debt levels are relatively high. The private sector

will have to play a key role in creating productive jobs for the new labor force

entrants, and a critical element of this is improving the economic climate to attract

private investment, a vital factor in sustainable and broad-based growth.

&hile greater domestic private sector investment is important, no country has

moved into middle' or upper'income status in isolation.

oreign private capital flows ! bank lending, direct investment and portfolioinvestment "i.e. debt and e#uity$ ! e%pand the potential sources of capital available

to countries, raising productivity and boosting growth. &tudies find that foreign

direct investment "'I$ has a potentially large role due to its relative stability

"(evchenko and )auro *++$ and its impact on transfers of knowledge and

technology ")oran, raham and lomstr/m *++0$. mpirical evidence points to

'I’s productivity-enhancing effects in advanced economies!on average a 1.2

percent increase in country-wide total factor productivity growth has been

associated with a 1+ percent increase in 'I! although the impact varies bycountry "it3er and /rg *++4$. 5ther research indicates similar outcomes in

developing countries6 the 73ech 8epublic and 8ussia "&abirianova 9eter, &vejnar

and Terrell *++0$, Indonesia "lalock and ertler *++:$, (ithuania ". &. ;avorcik

*++:$, among others. lonigen and sia region refers to >fghanistan, angladesh, hutan, India, )aldives,

?epal, 9akistan, and &ri (anka. The I)’s most recent alance of 9ayments

)anual "9)@$ defines 'I as Aa category of cross-border investment associated

with a resident in one economy having control or a significant degree of influence

on the management of an enterprise that is resident in another economy.B This is

operationally defined as having at least a 1+ percent e#uity stake in the foreign

firm. Inward 'I refers to foreign investment flows into the home countries,


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*

whereas outward 'I is the countries’ investment flows to other countries. 'I is

classified by two types6

reenfield investment involves constructing new operational facilities "factories,

machinery, etc.$ from the ground up and )ergers and ac#uisition ")C>$ involve

foreign firms ac#uiring e%isting assets from local firms. 5ur analysis in this study

will cover both types of 'I together, although the literature has sometimes made a

distinction between these two entry modes of 'I in terms of their impact on

productivity, growth, and jobs. &ome empirical studies suggest that greenfield

investment and )C>s are not perfect substitutes "lonigen 144D ?ocke and

Eeaple *++and *++FD and ?orbGck and 9ersson *++FD ertrand, Hakkala and

?orbGck *+1*$. The choice of entry modes may influence 'I performance and the

host country’s performance through research and development "8C'$, locali3ation

of supplies and human resources, and technology transfers. In fact, a group of

studies including 7aldern, (oay3a and &ervJn "*++:$, =im and Khang "*++F$,


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determinants of 'I flows as a share of '9, taking &outh >sia as focal point

due to its low current levels, despite the region’s relatively high '9 growth over

the last decade.

&hile )I !lows have increased over the past decade to South Asia,

particularly !rom developed countries to South Asian service sectors, it has

lagged in other sectors and remains relatively low overall. It is interesting to

note, however, that one of the region’s bright spots!which is common to other

developing regions!is the increase in 'I flows from other developing countries.

In other words, the traditional pattern of capital flows going in one direction!from

rich to poor countries!is changing, with increasing flows and technology e%change

taking place between developing countries themselves. This reflects the more

integrated and diversified nature of capital markets and the changing nature of the

global economy, where the center of gravity in economic activity has gradually

shifted toward developing countries.

*y examining the historical patterns o! South Asia+s )I, the policyenvironment, and the connections between the two, this study will provide the

context !or policy makers in South Asia and other developing countries to

identi!y strategies, ease constraints to )I, and boost potential

or e%ample, interview with ;oseph &tiglit3, The Times of India, 5ctober *1,

*+1* and the work of Hellman, ;ones and =aufmann "*++*$ and olberman

and &hapiro "*++2$.

*road'based growth' as noted by lonigen and


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the service sectors, with India accounting for the majority of the absolute flows.

8elative to '9, however, India does not stand out as a large recipient.

Interestingly, while the number of developed countries investing in &outh >sia has

remained roughly the same over the last decade, the number of other developing

countries investing in &outh >sia has almost doubled! suggesting greater &outh-

&outh linkages. Intra-&outh >sian 'I flows remain #uite small, particularly

because the two largest &outh >sian countries, 9akistan and India, maintain strong

restrictions on investments from each other.

ollowing this, we examine policy, legal, and regulatory investment issues in

South Asia to better understand overall incentives and disincentives to )I

in!lows and out!lows in the region+s institutional !ramework. 5verall, positive

changes have taken place over the past few decades, while restrictions on 'I

differ substantially among countries in &outh >sia. India’s progress on 'I-

promoting policies has accelerated in recent years to make 'I policies more

transparent, predictable, and simpler. )any other countries have also taken steps to

improve transparency in regulations and reassure investors about the security of their investments in the country. ?onetheless, restrictions on outward 'I and

capital account restrictions remain, and behind the boarder constraints to investing,

such as clear and enforceable contracting, remain a challenge for foreign investors

and domestic investors alike.

inally, the paper examines the determinants o! )I growth in South Asia.

sia’s current

low levels of 'I, as well as opportunities for liberali3ing policy constraints in both trade and foreign investment. (owering corporate ta% rates and improving

governance and transparency would also be important contributors to increasing the

growth in 'IM'9. )aking progress on all of these areas could help to

substantially improve 'I flows into &outh >sia and enhance the region’s growth

and productivity, as indicated by the e%perience of other regions.


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0

lobal )I and South Asia+s )I /xperience

lobal )I has increased substantially since the 01#s, and it is now among the

largest !orms o! cross'border capital !lows. s a source of capital flows, 'I may e%hibit lower

volatility than other types of capital flows, such as debt and portfolio e#uity. The

stability of 'I is especially relevant during Asudden stops,B or interruptions on

capital flows. 7apital flows skewed toward non-'I types, such as bank lending

and portfolio investments, may lead to increased vulnerability to economic shocks.

This pattern certainly played out in &outh >sia during the global financial crisis that

began in *++F "see chart below$. 8egardless of the source of capital flows,

significant volatility suggests that there is room for countries to invest in institutions

and programs that would help reduce their populations’ vulnerability to

increased e%posure to global "and regional$ economic shocks.

rowing international capital !lows have become an increasing share o!

employment in developing countries, including those in the South Asia region.

lobally, employment in wholly or partly foreign- owned companies has increased

in the recent years, accounting for @4 million jobs in *+11, an F percent increase

over the previous year. y contrast, overall job growth in the same period was *

percent "N?7T>' *+1*$.


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@

Traditionally, global 'I has mostly flowed between developed countries!for

e%ample, the Nnited &tates investing in


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the first time recent history, more than half "01.@ percent$ of the world’s total 'I

inflows were received by developing countries "igure *$. This reflects more

integrated and diversified markets as well as the gradual shift of the global

economy’s center of gravity toward developing countries. > similar but less

pronounced trend has occurred in 'I outflows. In *+++, developed countries were

the largest source of outward 'I, with 4+ percent of the total, but their share has

fallen to + percent "igure 2$. This also reflects greater globali3ation of capital

markets and the growing prominence of developing economies in global supply-

chain linkages, with their growth-enhancing spillover effects.

Since the "##1'#0 global !inancial crises, developing countries+ increasing

importance has become even more pronounced in global )I !lows2both

inward and outward. &tress in global financial markets, risk aversion, and

uncertain profits made it more difficult to finance )C> across the globe. In this

tough environment, 'I inflows actually contracted more in developed countries

than in developing ones. In *++-+4, developed counties’ inward 'I flows declined

02.4 percent, while flows to the developing countries fell by only 1*.2 percent.

To a large extent, trends in global outward )I !lows mirror inward )I

!lows. 5utward flows from developed countries e%perienced a :@.* percent decline

in *++-1+. 5utward 'I flows from developing countries also fell over the same

period!but by just F percent.


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F

The lobal 3ontext4 )espite ast rowth, South Asia+s )I Is Low

South Asia+s )I in!lows as a share o! )- are among the lowest o! all

developing regions and can be a good case study to examine !or other regions

and countries con!ronting low )I. &outh >sia is one of the world’s fastest

growing regions, averaging @. percent annual increases in real '9 over the past

decade "igure :, left$. However, &outh >sia’s 'I inflows as a share of '9 arethe lowest of all developing regions, averaging less than * percent in *+++-11

"igure :, right$. >lthough the gap had been narrowing, it reversed somewhat

after the global crisis. &outh >sia’s economy is almost twice as large as &ub-

&aharan >frica’sD yet over the *+++-11 decade, &outh >sia’s average annual

inward 'I flow of N&O1F.2 billion was smaller than &ub-&aharan >frica’s

N&O14.: billion.

In this report, developing economies include both developing and transitional

economies as defined in N?7T>'. A'I inflowsB are defined as net investments in

domestic firms by foreigners. This is a different concept then AnetB 'I "net

investment in domestic firms by foreigners minus the net purchases of foreign firms

by domestic agents$. "roner, et al. >ugust *+11$ find that AgrossB capital flows

tend to be more volatile than AnetB capital flows.


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h tt p 6MMda ta . w o rl db a n k .o r g Ma b o u tM co un try - c la ss i f ica ti on sM c ou n tr y - a nd -le nd in g - g r oup s .

'I to '9 ratios are fre#uently used to control for the si3e of the economies when

doing comparisons of 'I.

India represents 1# percent o! South Asia+s )- and accounts !or about 15

percent o! its )I in!lows. 'espite the high absolute 'I flows, India’s inward

'I relative to the si3e of its economy is #uite low compared to countries of

similar economic si3e. >lthough India was the second largest developing economy

in terms of total 9urchasing 9ower 9arity "999$ '9, it was the eighth largest 'I

recipient among developing countries in *+1+, according to the *+11 '. >mong developing countries, by

contrast, 7hina is the largest economy in terms of 999 '9 and the largest 'I

recipient.

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1+

6egional South Asian Trends

Across South Asian countries, )I in!lows vary widely as a share o! )- . The

differences reflect geography, levels of development, availability of basic

infrastructure, the regulatory frameworks on 'I, and the si3e of the economies

themselves. It may be e%pected that relatively larger!and perhaps more volatile!

'I inflows would be found in smaller countries simply because domesticinvestment may be less plentiful, allowing firm-level investment decisions to play

a larger role in the overall economy. Indeed, the )aldives has the region’s

smallest economy but ranks highest in 'I inflows as a share of '9 at almost 0

percent. >fghanistan, 9akistan, and India follow in the ranking. angladesh, hutan,

and &ri (anka are below the &outh >sian average "igure 0$. ?epal received the

least 'I as a share of '9.

)I in!lows, like port!olio capital in!lows, move with the global business cycle7

during the recent global crisis, )I dropped in nearly all South Asiancountries2some more than others. In relative terms, 9akistan was the most

affected by the global crisis. It e%perienced an F2 percent drop in inward 'I

flows as a share of '9 during in *++-11 "igure @$. (ooking at absolute levels,

both India and 9akistan had significant declines in 'I inflows after the crisis in

*++F "Table 1$. India e%perienced a :: percent slide in 'I between *++F and

*+1+. 9akistan was affected even more. >nnual 'I to the 9akistani economy


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fell by @2 percent during the same period and continued to fall in *+11. oreign

investors, particularly from urope and the Nnited &tates, suffered higher

economic uncertainty, which may have led to the decrease in 'I. The fall was

compounded by 9akistan’s weakening macroeconomic environment, combined

with security issues and political uncertainty. Nnlike 9akistan, India’s absolute

inward 'I flows rebounded in *+11. The country’s 'I saw additional but

more modest growth in *+1*.

8ost countries have seen a recovery in )I !lows a!ter the global crisis. In

*++4, )aldives’ 'I was 1 percent less than its *++F level!but it has since

more than recovered and is now higher than before the crisis. In angladesh, the

financial crisis caused a *+ percent decline in inward 'I, but it rebounded in

*+11 and signs point to further recovery in *+1*. >mong some countries, 'I

tends to be less correlated to the global business cycle, but can be subject to large

discrete investments, such as mining projects in >fghanistan. oth hutan and

?epal have relatively low 'I levels, and what they receive is linked to large

public-sector investments from India. hutan’s 'I has recently averaged about

N&O10 million a year since *++4. ?epal’s 'I has progressively increased from

N&O1 million as recently as *++F to over N&O40 million in *+11. )aldives

receives the largest share of 'I in '9, due to the small si3e of its economy and

large inflows of 'I into the tourism sector.


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1*

Sectoral 3omposition o! )I in South Asia and 9ther 6egions

)I in!lows into South Asia are concentrated in the service sector, while

investments in manu!acturing and agriculture and mining are much smaller

(igure :$. > snapshot of the *++4 statistics shows that the service sector

accounted for * percent of total inward 'I in &outh >sia ": percent in India$,

making &outh >sia second only to the urope and 7entral >sia region "Table *$.

&outh >sia also ranks second among all developing regions in dollar value 'I

flows into the service sector! around N&O1.4 trillion in *++4. However, &outh

>sia’s service sector 'I inflows are not e%ceptionally high as a share of '9. This

reflects the region’s low overall 'I inflows!at 1. percent of '9, the lowest

among si% regions and well below the developing country average of more than 2

percent "Table 2$. >s percent of '9, 'I flows into the &outh >sian service sector

ranked fourth among the si% regions in the developing world. sia,

especially India, is one of the largest international hubs for the service industry,

particularly usiness 9rocess 5utsourcing "95$, overall inward 'I flows as a

share of '9 compared to the other regions remain modest.

3ompared to other regions, South Asia+s )I in!lows into manu!acturing and

agriculture and mining are also modest as a share o! )-. (ooking again at the

si% regions in Table 2, &outh >sia was ne%t to last in 'I flows into manufacturing

and tied for last in agriculture and mining.


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The service sector includes6 financeD wholesale and retail tradeD business

activitiesD transport, storage and communicationD electricity, gas and waterD hotels

and restaurantsD health and social servicesD educationD constructionD community,

social and personal service activitiesD public administration and defenseD and other

services.


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Source 3ountries !or South Asia+s )I In!lows


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The number o! developing countries investing in South Asia has increased in

recent years, which re!lects a global trend o! more south'south )I !lows.

rowth in the number of countries investing in &outh >sia may suggest greater trade

linkages and knowledge spillovers between developing countries and industries, rather

than the e%pansion of investments from a single country with only marginal additional

knowledge spillovers. >s Table : shows, the number of developing countries with

'I positions in &outh >sia increased from 2F to :0 between the early and late *+++s,

while the number of developed countries making investments in &outh >sia grew by

only one "reece$.

Table 4: FDI into South Asia: Source Country Counts

Developed Developing Tot

2003-2006 2 38 61

2007-2010 2 45 69

Source: World Bank Staff estimates from !"#$% statistics and %imarkets

)espite the growing number o! developing countries investing in SouthAsia, the developed countries still lead in the value o! )I2and this edge has

risen since the "##1 global economic crisis. The value of developing country

investments increased for much of the *+++s, hitting a peak of N&O@+2 billion in

*++F, or about 24 percent of total inflows. However, the developing countries’ share

fell back to about *+ percent in *+1+ "igure F$. The global financial crisis’ relatively

harsher impact on developed economies spurred greater 'I flows into developing

countries "hence increasing developed country shares of 'I and lowering developing

country shares$, including &outh >sia. stimates for *+1* suggest that the largestdeclines in the developing nations’ share of &outh >sia’s estimated 'I inflows were

from *++4 to *+1+.

Figure 8: Developing Country Share of Inward FDI into South Asia

45

40

35

30

25

20

15

10

5

0

2003 2004 2005 2006 2007 2008 2009 2010

Source: !"#$% statistics& f%i'arkets and World Bank staff calculations

rom "##; to "#, almost :# percent o! South Asia+s inward )I was !rom

developed countries, including ;" percent !rom the /


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countries investing in &outh >sia, the largest shares of inflows arrived from the

)iddle ast and ?orth >frica ")?>$ and the ast >sia and 9acific 8egions ">9$.

&outh >sia itself accounted for almost : percent of 'I within the region "igure 4$.

(ooking at specific developing countries, the Nnited >rab mirates contributed F.0

percent and

7hina "including Hong =ong &>8, )acau, Taiwan, and mainland 7hina$ supplied

@ percent.

India contributes :# percent o! intra'regional South Asian )I7 however, total

within'region )I represents %ust ;.: percent o! all inward )I in South Asia. The

largest sources of inward 'I vary substantially across &outh >sian countries, but

historical bilateral restrictions on 'I inflows from other &outh >sian countries have

limited intra-regional flows. >s shown in Table 0, 'I flows to India come primarilyfrom developed economies, such as the N, Nnited &tates, ;apan, and &outh =orea. In

contrast, 9akistan’s inflows are dominated by capital from the )iddle ast, while

angladesh’s and &ri (anka’s 'I comes from a handful of countries, including the N,

Nnited &tates, India, and 7hina. The )aldives has perhaps the most diverse spectrum of

countries contributing 'I, including Thailand, India, Nnited &tates, the N, and 7hina.

(andlocked hutan and ?epal depend heavily on India for investment in their countries.

7hinese companies have made large investments in e%traction businesses, which account

for a large portion of the 'I in >fghanistan. 7hina has also been active in ?epal’srenewable energy sector and in &ri (anka’s transportation sector, specifically building

ports, but also in constructing hotels and investing in &ri (anka’s tourism sector.


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The South Asia region is becoming increasingly attractive to )I, but )I

policies remain !airly restrictive. 5verall, positive changes have taken place over the

past few decades. The more advanced economies in &outh >sia have tended to move

more #uickly toward 'I liberali3ation and have more 'I-friendly policies.

?onetheless, investing across &outh >sia still faces significant barriers. The region has

lagged in liberali3ing policies that directly promote 'I, although it has pursued a

number of trade- promoting agreements, which research shows also have a positiveimpact on 'I.


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)estination 3ountries !or South Asia+s )I 9ut!lows

South Asian !irms, particularly in India, have increased their strategic outward

investments. Improving ownership-specific advantages and increased financial

capabilities have also played important roles in the strategic shift. 5utward 'Iflows from &outh >sia to the rest of the world took off in *+++, almost entirely

because of India’s more open stance toward outbound 'I. India’s outward 'I

more than doubled in *++1 to N&O1.: billion and then jumped again to N&O1:.*

billion in *++@. >lthough Indian firms had been investing overseas for decades,

marked jumps in outward 'I occurred in the 144+s after market liberali3ation

and again in early the *+++s after liberali3ation of foreign e%change transactions and

gradual reductions in the limits on how much firms could invest abroad.

In *+++, the Indian government implemented the oreign %change )anagement

>ct ")>$ to facilitate e%ternal trade and payments, providing a sound framework

for cross-border investments. In addition, the uidelines for Indian ;oint Pentures

and broad, as amended in 5ctober 144*, )ay 1444,

and ;uly *++*, provided for automatic approval of outward 'I proposals up to

certain limits. The government raised the limit progressively from N&O* million in

144* to N&O1++ million in ;uly *++*. In ;anuary *++:, the limit was removed

altogether, and Indian enterprises are now permitted to invest up to 1++ percent of

their net worth abroad on an automatic basis "=umar, *++F$. (ike other large

developing countries over the same period, India has seen an increase in outward

'I flows.

In *++@, the >greement on &outh >sian ree Trade >rea "&>T>$ was launched to

reduce trade barriers within the region, although much remains to be implemented.

In addition, three bilateral free-trade agreements have been signed6 India-hutan,

India-&ri (anka, and 9akistan-&ri (anka. 5ther trade agreements that incorporate

&outh >sian countries include the >sia-9acific Trade >greement "India,

angladesh, &ri (anka, 9hilippines, (ao 9'8, and =orea$ as well as the ay of

engal Initiative for )ulti-sectoral Technical and conomic 7ooperation

"I)&T7$, which involves angladesh, hutan, India, )yanmar, ?epal, &ri

(anka, and Thailand, aims to achieve its own free trade area by *+1.

The oreign %change )anagement >ct "1444$, or )>, was introduced to

replace the oreign %change 8egulation >ct "8>$. )>’s main objective was

to consolidate and amend the law relating to foreign e%change, with the objective of


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facilitating e%ternal trade and payments. It took effect ;une, 1, *+++. )> was

introduced because the 8> didn’t fit with post-liberali3ation policies. In a

significant change, )> made all offenses regarding foreign e%change civil

offenses, ending the criminal penalties dictated by 8>.

South Asia+s outward )I in "##5'# totaled fter India, the

largest flows of outward 'I from &outh >sia are from angladesh, 9akistan,

and &ri (anka. The other &outh >sian countries, however, show little outward

investment "Table @$.


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&ome of the possible drivers for outward 'I include "8ajan *++4$6

Q )arket access6 y undertaking overseas ac#uisitions, firms gain entry into

the regulated markets of developed countries. The best e%ample is the Indian

pharmaceutical industry, where firms with N& '>-approved facilities are

looking for ac#uisitions in regulated foreign markets to ease the registration

processes. The manufacturing activities will still be in India, taking

advantage of lower costs.

Q Transfer of technology6 )anufacturing certain products re#uires technology

that is not available to local companies. y ac#uiring companies abroad,

they get access to advanced manufacturing technologies that further help

reduce production costs.

Q ?ew product mi%6 7ompanies are also going abroad to broaden their

product mi%es or ac#uire products that will otherwise re#uire huge

investments and a long time to manufacture indigenously.

Q 9resence in a location6 7ertain industries spread around the globe through

subsidiaries to cater to the tastes and preferences in a particular region. The

ac#uisitions made by these companies are primarily for added value in their

product profile.

Q &ecuring access to raw material6 The rapid growth of many largedeveloping countries!in particular, 7hina and India!is causing concerns

about the availability of, and access to, key resources and inputs for

continuing economic e%pansion. Investing abroad will help ensure

availability and cost of inputs.

)eterminants o! )I4 An /mpirical Analysis


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&o far we have detailed the general trends in 'I to the developing countries and

&outh >sia in particular. In this section, we look at some of the key

determinants of these trends to get insights into how developing countries in

general may stimulate 'I, taking &outh >sia as one case study. 5nce the

magnitudes and determinants of 'I are known, policy makers can direct their attention to enhancing the factors that are most critical to attracting 'I. Increased

'I can be a powerful complement to leveraging the competitive potential of &outh

>sia, a region highly abundant in labor and natural resources.

&hat 8ight *e the >ey )eterminants o! )I?

6esearch on the determinants o! )I in!lows is uite advanced. &everal

approaches have been taken, including looking at the patterns of 'I over time for a

particular country, or a set of countries, as well as cross-country analysis, e%amining

what determines 'I in countries based on certain economic, institutional,

geographical, and policy characteristics. ecause our main interest is identifying

factors that may enhance 'I flows for developing countries, we model

'I growth as a share of '9 as a function of key policy and economic

fundamentals!those that have been found to be critical in influencing investors’

decision-making as well as those that may be particularly important in developing

countries, such as energy availability, the level of trade barriers, and institutional

capacity.


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The speci!ication o! variables is based on the previous literature, with some

notable innovations.

Nnlike prior formulations, this analysis considers the long-run growth of 'IM'9"rather than the 'IM'9 levels or short-run movements$ and controls for the initial

'IM'9 stock to account for pre- e%isting conditions that may have determined

prior levels of 'IM'9. This formulation was used for several reasons, including6

1$ it provides a method for determining whether 'IM'9 is converging or

diverging between countries, based on the coefficient on the initial stock of

'IM'9, *$ reduces the likelihood of endogeneity "although does not eliminate it$

and limits the noise of short-term fluctuations because the e%planatory variables are

average growth from the first part of the period, rather than simultaneous with the

dependent variable and 2$ allows some means for looking at the dynamics of 'I

without use of a panel data set, which increases the number of observations

available and allows us to include most of the &outh >sian region in the data.

A high initial )I@)- level may be a conduit !or high !uture )I@)-

growth, signi!ying strong institutional ualities, agglomeration e!!ects, and

other !actors, or it may point to lower !uture )I@)- growth due to

diminishing returns on )I investment in a market that may already be well

developed. The past decade suggests the latter effect may dominate because thestock of 'I remains highest in developed countries, but recent growth has been

highly concentrated in developing countries.


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*2

&hat Are the 3omponents o! the Analysis?

The analysis uses cross-country data from F developing and developed

countries between *+++ and *+1+. >ll variables, e%cept initial 'IM'9 level

and natural resources per capita, are average annual growth rates for *+++-+0

and *+++-1+ and are calculated as R" ̇ M 1$"1M $S1, where is the observation

of the last year, i.e. R11 for time period *+++-1+ and R@ for time period

*+++-+0, 1 is the observation for the first year "*+++$. The dependent variable

is the growth of inward 'IM'9 from *+++-1+, and the independent variables

are all growth rates over the first half of the period!with two e%ceptions. The

initial level of inward 'IM'9 is the arithmetic average of the variable over

the first half of the period and natural resources per capita is measured in *+++

because it does not change much over the period under study and is a stock

variable. > brief description of each of the variables and their e%pected impact

on the growth of inward 'I follows6

Inward )I Stock as a Share o! )-4 >s is discussed above, growth of

inward 'I stock as a share of '9 is the dependent variable!ultimately, the

variable of interest. However, its level at the beginning of the growth period is

an e%planatory variable and plays an important role in our analysis. It pro%ies

for all the initial conditions the regressors might have on 'I growth, whether

it is a low tariff rate at the start of the period, energy availability, or other

factors. It may have a positive or negative sign depending on whether the

agglomeration effect "greater 'I attracts more 'I$ outweighs the

convergence effect "diminishing returns to additional 'I$. 'ata on the inward

'I stock are from N?7T>' &tatistics, 7atalogue of oreign 'irect

Investment.

3orporate Tax 6ates4 Higher corporate ta% rates are e%pected to act as a

deterrent to 'I by decreasing investment returns. In this study, we use total

ta% rate "as a percentage of commercial profits$ available from the


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*:

macroeconomic stability, we use the coefficient of variation for the real

e%change rate, controlling for the domestic and N& 79Is. garwal 14F+$. In this study, we use the educational

attainment data set provided by arro and (ee on their website.

Buality o! Institutions4 The role institutions play in all globali3ation-related

issues, including financial globali3ation, has gained increasing attention in

recent decades. etter institutions decrease all types of costs!such as

financial, time, and effort costs!related to starting, continuing and even

ending a business. They also help create a more business-friendly economic

environment by increasing the transparency of rules and regulations and

decreasing the information asymmetry in investment-related activities. In this

study we use measures of 7ontrol of 7orruption and 9olitical &tability data

available in the


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*0

investment returns. This study relies on the most fre#uently used data on

infrastructure!the I7T infrastructure data, which can be found in the pplied tariff rates are the pro%y for

trade openness. The data come from N?7T>' &tatistics, 7atalogue of

International Trade under the A)arket >ccessB category. >lternative measures

of trade policies are also used, such as the ratio of imports and e%ports to '9

and the 5verall Trade 8estrictiveness Inde%, available from the


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*@

inancial )evelopment4 5n one hand, financially developed economies

ensure the availability of re#uired capital for production and may act as an 'I

deterrent. 5n the other hand, financial deepening can also decrease transaction

costs of investment and facilitate all sorts of financing activities, thus playing a

key role in attracting 'I ">l ?asser and ome3 *++4$. >s in other studies,

financial development is measured by the private credit to '9 ratio, available

from the


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*

9ne !actor that appears signi!icant as a determinate !or )I@)- growth

is a rate reduction in corporate taxes as share o! pro!its (particularly !or

the developing country sample$. or developing countries, lowering corporate

ta% rates may have a predominantly positive impact on 'I, especially if ta%es

are imposed more stringently on foreign-owned enterprises than on domestic

ones. > one percent decrease in corporate rates would cause about a half a

percentage point increase in 'IM'9 growth.


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*F

Another signi!icant !actor is increasing trade liberaliDation. > one percent

decrease in tariff rates would cause about a +.12 percentage point increase in

growth in 'IM'9.


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*4

sample, as indicated by the adjusted 8-s#uare.21 The summary statistics of the

variables are presented in the >nne%.

ow )oes South Asia 6ank among 9ther )eveloping 3ountries?


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2+

The series o! graphs in igure compares South Asia and other

developing regions on the explanatory variables used in the regression

analysis. India and the rest of &outh >sia stand out generally as having a weak

environment for attracting 'I. It had the lowest initial level of inward

'IM'9. It had the lowest reduction corporate ta% rates as a share of profits

"and actual increases in &outh >sia e%cluding India$. It has had the largest

decline in investment policy openness, the lowest level of natural resources per

capita, and largest deterioration in political stability "particularly for &outh >sia

e%cluding India$.

South Asia does well on some indicators. The region’s human capital growth

has been stronger than other regions, it has the largest reduction in energy

losses "despite only weak improvements in India$, financial sector development

growth is second only to the urope and 7entral >sia region, and infrastructure

growth has been second only to &ub-&aharan >frica. or India, trade

liberali3ation "as measured by reduced effective rates of tariff protection$ and

investment policy openness has been particularly strong during this period,

while for the rest of &outh >sia it has shown only modest improvements or

deterioration. However, with the e%ception of overall trade liberali3ation and

investment policy openness in India, these factors are not found to be

significant determinants of 'IM'9 in the regression analysis, but they may

be important contributors to growth. This may partly e%plain the region’s

relatively strong '9 growth over the past decade, despite a period of

relatively weak growth in 'I inflows.


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21


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2*


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22

Accounting !or )I rowth23omparing South Asia to 9ther )eveloping

6egions


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2:

corruption and corporate ta% changes, have been #uite similar to the rest of

&outh >sia. or 9akistan, reductions in corporate ta% rates have been a large

positive factor in enhancing 'IM'9 growth compared to other developing

countries and the rest of &outh >sia, while control of corruption and

improvements in investment policy growth have been relatively large

detractors.

9verall levels o! )I to )- are relatively small in *hutan and Cepal,

suggesting a large potential !or !uture growth in !oreign investment, which

are complemented by high natural resource endowments due to the

unexploited hydropower potential. ?onetheless, the deterioration in

investment policies has been a relatively large deterrent to foreign investment

growth in ?epal. or the )aldives, the current large stock of 'I to '9

suggests that potential for future growth in foreign investment is modest.

3ontrol o! corruption is a signi!icant detractor to the growth in )I@)-

!or most countries in the SA6 region, with the exception o! *hutan, where

improvements have been a positive contributor to !oreign investment.

However, hutan has raised its level of trade protection, somewhat offsetting

the positive impact of the gains through controlling corruption.

The estimated model suggests potential !or improving )I in!lows to South

Asia via policy enhancements. Table F shows actual and predicted 'Is from

*++0 to *+10. The actual annual growth of 'IM'9 fell for most countries in

&outh >sia in the second half of the *+++s, on average decreasing from @.0

percent to 1.0 percent with the e%ception of India and 9akistan. India’s

'IM'9 growth increased from @. percent during *+++-+0 to 1:.4 percent

over *++0-1+, while 9akistan’s rate increased from -+.@ percent to 2.2 during

the same period.

sian countries.


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20

An alternative !orecast is provided in column E, which makes a

hypothetical !orecast that assumes that South Asian countries are to make

progress on policies that attract )I@)- (up to the developing country

average$ and maintain their other policies that are already above average.

Nnder this scenario, annual 'IM'9 growth would increase to @.@ percent

through *+10, which is *. percentage points higher annually than if policies

were maintained. 5verall, the results suggest &outh >sia has the potential,

through policy changes, to take important steps to becoming a much greater

magnet for foreign investment.


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2@


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2


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2F

3onclusions

lobally, inward )I !lows have !ollowed a hump'shaped pattern over the

past decade, with strong growth be!ore the global crisis and a sharp drop as

many economies struggled during "##1'"##0. 'I inflows to developed

economies fell significantly in the midst of the crisis, and have yet to fully

recoverD by contrast, 'I flows to developing economies have begun to recover

more rapidly than many forecasters would have predicted. 8ecent decades have

seen a gradual shift of the center of gravity for 'I inflows from developed

economies to developing ones. 7urrently, more than half of the 'I goes to

developing countries. &trong growth in the developing countries, overall

improvement in their business environments, and more open 'I policies have

played a large role in the paradigm shift. )any emerging economies have been

actively courting 'I from both advanced and other developing countries.

They’re doing so to take advantage of supply-chain linkages, technology

transfers, and natural resource opportunities. India has been a notable player in

this process.

&hile South Asia has seen )I increases in the past decade, as have other

regions, the region+s challenges put in sharp contrast policies that can

impact )I !or all developing countries.


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24

percent in *+1+ to 0.: percent in *+1*, and some local businesses are

advocating #uick short-term solutions through protected markets. 7oncerns

have recently been raised by multinational corporations that new policies to

protect domestic business are deteriorating the attractiveness of investing in the

region, and thus may hurt long-term growth prospects. Initiatives to promote

domestic interests, while at first appearing to help strengthen the domestic

economy may, in the end, do just the opposite.


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