Maximising the benefits of foreign direct investment

By Stephen Thomsen, Senior Economist, OECD Investment Division

The potential benefits of foreign direct investment (FDI) are now widely accepted by policy makers. In the right conditions, FDI can bring the capital essential for meeting the Sustainable Development Goals, technology and improved ways of doing business, and it can create jobs and foster exports. So it’s not surprising that governments compete actively to attract investors through generous tax incentives and other inducements. But governments also recognise that the benefits of FDI are not automatic – private returns and societal ones are not always the same thing.

Governments have many tools to try to shift this balance in favour of host country benefits. One of the most common approaches is to impose restrictions on the activities of foreign investors. Local content rules are designed to promote local suppliers. Restrictions on foreign managers and technicians are supposed to create jobs for skilled local workers and facilitate local learning. Foreign equity limits protect local companies and force investors to share technologies and profits with local partners. Approval mechanisms for foreign investment can serve as a means to extract the most commitments to the local economy from individual investors on a case-by-case basis.

Maximising the benefits and minimising the costs of private sector activity – in this case involving foreign investors – is a laudable policy goal. A discussion of whether FDI restrictions are the best means, or even an effective one, to achieve this would fill volumes. Many studies have found that they are often not only ineffective but also sometimes counterproductive. The question here is rather whether they serve to deter potential foreign investors. Public officials in the countries concerned often say that these restrictions are simply seen by investors as the price of entry, with little influence on their decision of whether to invest. New OECD research suggests otherwise. Discrimination against foreign investors imposes a cost in terms of reduced FDI inflows into an economy. Statutory restrictions on FDI, as measured by the OECD FDI Regulatory Restrictiveness Index, have a significant impact on the stock of FDI within an economy. In the most restrictive countries, the stock could be around twice as high in a more liberal environment.

It’s not hard to see why this might be the case, especially when such restrictions are combined with other weaknesses in the business climate. Take equity restrictions, for example, which are the most prevalent form of discrimination foreign investors face. Investors might sometimes be happy to work with a local partner to navigate local regulations or cultural idiosyncracies in some markets, but an imposed limit on an investor’s control of an affiliate might be a deal-breaker in an environment with a poor corporate governance culture (such as when protecting minority shareholders’ rights) or weak intellectual property rights protection. For these and other reasons, control matters. Fully 92% of the largest 38 000 foreign affiliates of US multinational enterprises in 2016 were majority-owned, for example.

It is for each government to assess the effectiveness of FDI regulations in achieving its policy aims; few governments leave it fully to the whims of the market in all sectors. But when they undertake this cost-benefit analysis, governments may wish to look again at their policy stance in light of the deterrent effect of restrictions on FDI inflows. They may decide that some restrictions are worth the cost, but until now it has not been fully clear what those costs are.

Resources

Mistura, Fernando and Caroline Roulet (2019), The determinants of foreign direct investment: do statutory restrictions matter?

Global foreign direct investment statistics

OECD Regulatory Restrictiveness Index

OECD investment policy reviews

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