Chapter 2
Literature Review
Overview of Literature Review
Over the last two decades the substantial progress toward removal of cross-border restrictions on international capital flows and the trend toward an integrated world economy have increased the growth of foreign investment activity. In addition to the general relaxation of capital controls by many nations, cross-border investment has been stimulated by the European economic integration process, the opening of eastern European markets, and the global wave of privatization. Aside from this, this practice was also stirred in Arabian continent. In connection, this paper attempt to determine if the regulation of foreign investment in Saudi Arabia is effective.
Apparently, it is often assumed that political economy involves an integration of politics and economics. It is less often conceded that the very idea of political economy rests one a prior separation of politics and economics. If economics and politics are conceptually combined, political economy cannot begin to involve a relationship between distinguishable activities (Caporals & Levine, 1992).The relationship between investment and prosperity was obvious to Schumpeter, who considered the capital investment at the first symptom of the economic boom, Also, Keynes in his well know book, The General Theory of Employment, Interest, and Money, treated the investment in the political context, by giving the social and political environment and the national characteristics, which determine the prosperity to consume. The well being of a progressive state essentially depends, for the reasons on the sufficiency of such inducements (Keynes, 1964). In his book, Capitalism and Freedom, Freidman tried to elaborate on the delusion of the separation between the economics and politics: “Economic arrangements play a dual role in the promotion of a free society. On one hand, freedom in economic arrangements is itself a component of freedom broadly understood, so economic freedom is an end itself. On the other hand, economic freedom is also an indispensable means toward the achievement of political freedom” It is widely believed that politics and economics are separate and largely unconnected; that individual freedom is a political problem and material welfare is an economic problem and that any kind of political arrangements can be combined with any kind of economic arrangements. The national saving rate has to equal the capital-output ratio and the rate of growth of the capital-output ratio and the rate of growth of the effective labour force. Then and only then could be the economy keep its stock of plant and equipment in balance with its supply of labour (Solow, 1970).
Basically, the topic of this research attempts to bridge the gap by analysing the effect of foreign investment to Saudi Arabia. Taking advantage of newly developed measures of economic freedom, it will analyse the impact of foreign investment regulation to Saudi Arabia. It is maintained that democracy is a luxury, which comes at a price in terms of subsequent slower increase in national living standards. However, various recent cross-section studies on economic growth have found evidence that lack of civil and political liberties is negatively correlated with economic growth. Jacob (1995) reviewed his research many empirical growth studies, and they reported different results. Disrupt (1990), and Hollywell (1992) concluded that there is a positive relationship between democracy and economic growth. However, Landau’s (1986) study found that there is a negative relationship between democracy and economic growth.
Foreign Direct Investment
In history, Saudi Arabia is the largest Persian Gulf oil Kingdom founded by King Abdul Aziza al-Saud in 1932. Through the years up to the current age, an absolute monarchy by the Saud dynasty was still the governing. After the death of King Fahd, the Crown Prince Abdullah officially became monarch last August 2005. Basically, Saudi Arabia plays a dominant role in the Organization of Petroleum Exporting Countries since it is the world’s leading oil producer and exporter. Its succession to the World Trade Organization in 2005 has led to gradual economic reforms, but recent debates about the king’s successor have increased political tension and slowed the reform process.
According to The Heritage Foundation (2007), the economy of Saudi Arabia is 59.1 percent free, based on their 2007 assessment. This percentage makes Saudi Arabia in the world’s 85th freest economy. Its overall score is 2.3 percentage points lower than last year, partially reflecting new methodological detail. Saudi Arabia is ranked 10th out of 17 countries in the Middle East/North Africa region, and its overall score is above the regional average.
From this report, the monarchy has begun to liberalize aspects of foreign investment, but immense barriers remain in effect. Financial markets in Saudi Arabia are distorted by government influence, and the legal system is similarly subject to political influence. Through this, an evaluation of Foreign Direct Investment (FID) issues should be considered.
Basically, Foreign Direct Investment (FID) is an extensive cross-border investment between a direct investor (either an individual or business entity) from a stronger economy and a direct investment enterprise in another country conducted by the previous trial purposes only, but to instead acquire a long-term relationship with the latter in order to serve its domestic markets, make the most of its resources, or create a stage that will serve world markets through exports (Capital Markets Consultative Group [CAC] Working Group, 2003; Jensen, 2003; United Nations, 2003).
In the long-term relationship, the direct investor is given an important role in the management of the direct investment enterprise activities, which includes the construction of long-term establishments (such as manufacturing facilities, bank premises, warehouses and other long-term organizations) and conducting investments, joint ventures, cross-mergers and / or acquisitions in the less-advanced economy. If the direct investor already gets hold of 10 percent or more of the ordinary shares or voting power of an enterprise abroad, a direct investment is now achieved. In this case, the activities covered include not only the initial transaction that forges the “FDI relationship” between the two parties involved, but extends to all subsequent transactions between them and among affiliated enterprises, reaching beyond the original direct investor and includes foreign subsidiaries and affiliates of the direct investor that are part of the “parent group” (CAC Working Group, 2003).
Meanwhile, flows that make up FID are capital (either provided by foreign direct investor to an FID enterprise or received from a FID enterprise by a foreign direct investor), the three components equity capital (i.e., the foreign direct investor’s purchase of shares of an enterprise in a country other than its own), reinvested earnings (i.e., the direct investor’s share of earnings not distributed as dividends by affiliates, or earnings not paid to the direct investor) and intra-company loans / debt transactions (i.e., the short-term or long-term borrowing and lending of funds between direct investors and affiliate enterprises), and the FID stock (i.e., the value of the share of their capital and reserves (including retained profits) attributable to the parent enterprise, plus the net indebtedness of affiliates to the parent enterprise) (United Nations, 2003, pp. 231-232).
Apparently, in the paper of Raymond Vernon and W.M. Davidson (1979), the emergence of the multinational private corporation as a powerful agent of world social and economic change has been a signal development of the post-war era. This evolution has been regarded with mixed opinions by public officials of the investing and the host countries, as well as by observers of international affairs.
Determinants of FID
FID theories explain the reasons why FID occurs and what factors affect FID flows. In this regard, the following theories have been cited: Homer’s Market Imperfections Theory, International Production Theory, Internalisation Theory and Dining’s Eclectic Paradigm.
Homer’s (1960) market imperfections theory suggests that firms constantly seek market opportunities abroad because of the thought that they may have certain advantages over their local competitors which they can generate from the fields of technology, management, marketing, or preferential access to raw materials or other inputs, advantages that cannot be utilized by their local competitors in their own local market due to the imperfections of their domestic market. In short, the foreign firm’s decision to invest overseas is a strategy to capitalize on certain capabilities not shared by competitors in foreign countries (Morgan and Kats Ikeas, 1997). This theory was supported by Kindle Berger (1969), who said that market imperfections themselves are the reason why FID takes place.
However, this theory has a flaw: even if the market imperfections theory was able to explain the capabilities or advantages of firms for products and factors of production, it does not explain why foreign production is considered the most desirable means of harnessing the firm’s advantage (Morgan and Kats Ikeas, 1997). Herein enters the International Production theory developed by Dunning (1980) and Fair-weather (1982).
International production theory suggests that the tendency of a firm to initiate foreign production will depend on the specific attractions of its home country compared with resource implications and advantages of locating in another country, and it asserts, as well, that not only do resource differentials and the advantages of the firm play a part in determining overseas investment activities, but foreign government actions may significantly influence the piecemeal attractiveness and entry conditions for firms (Morgan and Kats Ikeas, 1997).
A related aspect of this foreign investment theory is the concept of internalization which has been extensively investigated by Buckley (1982) and Buckley and Caisson (1985).
Internalization theory hypothesizes that firms will gain in creating their own internal market because transactions can be carried out at a lower cost within the firm, and this will be made possible through internalization, which involves the extension of direct operations of the firm and bringing under common ownership and control the activities done by intermediate markets that link the firm to customers (Morgan and Kats Ikeas, 1997, pp. 70-71).
Meanwhile, John Dining’s eclectic paradigm explains that international production is motivated by three sets of advantages perceived by firms. The first set is a firm’s ownership-specific advantages, which include its ownership of intangible assets (product innovations, management practices, marketing techniques, and brand names) and common governance of cross-border production (Li and Redneck, 2003). Accordingly, diversification across borders allows a firm to exploit economies of scale and to develop monopoly power based on its size and established position; although, the foreign investor’s ownership-specific advantages are sensitive to property rights protection in the host country (Li and Redneck, 2003).
The second set of advantages concerns the firm’s internalisation advantages deriving from its hierarchical control of cross-border production. Basically, internalisation refers to a firm’s direct control over its value-added activities in multiple countries, as opposed to outsourcing, trade, or licensing ( 2003). In connection to this, the size of a firm’s internalisation advantages correlates with the degree of transnationals market failure (e.g., where the risks of opportunism by foreign buyers and sellers are high, such as disrupting supplies and violating property rights in primary product and high technology industries, the firm has an incentive to claim hierarchical control of cross-border production), where the greater the internalisation advantages, the more likely a firm is to pursue international production—hierarchical control of its assets, instead of trading or leasing (Li and Redneck, 2003) Nevertheless, the exploitation of these advantages is affected by the antitrust or competition-oriented regulation in the host country (Li and Redneck, 2003).
The third set of advantages refers to the location-specific advantages perceived by firms or the characteristics of host countries in terms of their economic environment or government policies, which may include scarce natural resources, abundant labour, high economic development, or favourable macroeconomic, microeconomic, and FID-specific government policies (Li and Redneck, 2003). Firms also consider government policies on tariffs, domestic corporate taxation, investment or tax regulation of foreign firms, profit repatriation or transfer pricing, royalties on extracted natural resources, antitrust regulation, technology transfer requirements, intellectual property protections, and labour market regulation (Li and Redneck, 2003).
International Trade
In this era of globalization, foreign investment and international movements of commodities have become the trend among globalise markets. Fundamentally, globalization brings an improved standard of living to the third world countries and wealth to the first world countries. While countries are making their way to globalization and international trade in particular, some economies remain steadfast on their trade policies which hinder economic development.
The occurrence of free trades leads to more allocation of resources between and among countries. Such will result to lower prices of commodities, more employment and the increased output of the economy. Indeed trade policies are the core element to the overall design of the economic development. Import substitution that is implemented in some economies may become productive but only in the early phase of the economic development and is against the principle of comparative advantage. With this concept, economies remain closed and thus do not benefit from the efficiency that is brought about by international trade. Moreover, it is evidenced that by countries such as Latin America and Africa that this kind of inward looking strategy is less likely to foster economic performance. On the other hand, the strategy adopted by Arab countries proved to be more efficient.
Ultimately, market liberalization paved the way for greater opportunities for economic development. As the resources are allocated more efficiently, the country can focus its efforts on its comparative advantage goods. The advantages that are likely to be gained from liberalism include the reduction of manufacturing costs and the low prices of goods. As such, the economy will be boosted and is bale to compete in the international market.
Lastly, the apparent impact of liberalism in the economic success has indeed prompted countries into the process of transition. However, such process entails the reduction of barriers and the implementation of measure on trade policies. International organizations that promote the reduction of barriers on international trades offer assistance to countries that aim to open its market to the free trade.
Global Free Trade
Primarily, countries trade because of the difference in resources which they possess. The efficiency of producing goods and services for the people varies from one country to another because of the different natural, human and capital resources they have as well as the ways by which such resources are combined. The production of a good or service is characterized by an opportunity cost which is referred to the amount of another good that could have otherwise been produced. As such, it is more efficient that the goods to be produced are those with the lower opportunity cost and instead increase the production of the good to be traded for those with higher opportunity cost (Why nations Trade, 2007).
Moreover, the ability of the country more of the good utilizing the same resources as other countries do, earns it an absolute advantage. In turn, if the second country has the absolute advantage of producing goods that the former want, then they can both specialize in the production of a specific good and engage in trading. Under these premises, it can be said that world trade is an equally beneficial strategy for the trading countries. The impact of globalization has paved the way for the liberalization of certain markets. This entailed the reduction of trade barriers and restrictions. The benefits presented by this resulted to the increasing amount and significance of international trade.
Fundamentally, the development of open market presents benefits to the society. Trade is often regarded by theorists as the impetus for economic prosperity. The impact of the increase in trading is reflected by the flourishing of the cultures such that of Egypt, Greece, Rome as well as East India and China.
Moreover, free trades foster comparative advantage. The trading of goods without barriers is beneficial to countries especially if one has gained more efficiency in the production of goods and services that are needed by the other country. Hence, the two countries can easily produce different goods that are both beneficial to them (Wikipedia, 2007).
Import Substitution vs. Free Trade
By import substitution, the focus lies on the creation of products locally to avoid the expenses associated with importation. However, the greater expense of manufacturing the goods on smaller scales curtails the development if compared to the discounts that can be taken advantage by large producers to offer lower prices of goods.
Initially, the General Agreements on Tariffs and Trade (GATT), an international organization promoting the reduction of international trade barriers, contains no explicit provisions on developing countries. However, concerns on challenges faced in the international trade were voiced out. One of which is the sustainable increase in income and output that is deemed to be brought by increase in industrialization. Some countries hold the idea that the liberal trade policies will not foster industrialization and development due to the patterns that prevails in the international specialization (Michalopoulos, 2001, p.23).
The tendency of developing countries lies on the specialization of raw materials and commodity exports that has low price and low elasticity of demand. Additionally, manufacturers are dependent on imports. With this, it was thought that the liberal trade policies stymied the development of infant industries. Thus, trade strategies emerged such as the promotion of industrialization through import substitution. This implied the protection of tariff and non tariff barriers. This strategy which gained popular development in the 1950s and the 1960s is an application of the infant industry.
Under the argument of infant industry, protection is warranted in firms especially those in less developed countries. Such argument was brought about the little chances of competing with established firms by new firms. Since firms in developed countries have been in the business for a longer period of time, they are deemed to be more efficient in terms of production. Moreover, the knowledge on the production process, market characteristics and the labour market enables the established firms to offer their products in the international market at a lower price but still remain profitable. Thus firms in less developed countries are protected to raise the price of domestic goods and reduce the import expenses. Upon the improvement of the production efficiency, the protective tariffs are gradually reduced until they are eliminated and the firm is capable of competing equally with those in developed countries (Serranoid, 2004).
Infant industries and externalities are treated by neoclassical economists as special cases. But even with the existence of such cases, it is arguable that interventions on trade are not the best option to solve the very core of the exceptions in the general case of free trade (Liang, 1997, p.23). The argument is applied to the import competing industries but it does not necessarily have to follow that the industries produced solely for the domestic market but they can target the international market as well.
However, the protection of infant industries does not foster the allocation of resources in terms of comparative advantage. Resources can be allocated more efficiently if countries are able to produce the goods in which the prices before trade are relatively lower than the rest of the world. This entails the importation of industrial goods and focusing on the resources that has a comparative advantage. This could have led to the maximization of the economic efficiency among and between countries.
The welfare effects of trade can be evaluated on the real wages of the workers in two countries moving from autarky to free trade. With the shift to free trade, the purchasing power of all the workers wages is likely to rise. The possible welfare effect of free trade is the equal benefit in both the trading countries. When both countries have their specialization on their comparative advantage goods, and therefore engage in free trades, they experience gains form the trade. Moreover, the move form the autarky to the free trade will lead to the aggregate production efficiency gains and aggregate consumption efficiency gains. Thus, both the producers and the consumers benefit from the free trade (Serranoid, 2004).Ultimately, international trade is driven by the differences in the price ratios between two countries and the desire to make profit.
Free Trade in Transition Economies
Transition economies that are integrating to the international trade face a challenging task. Important issues are raise among developing countries despite efforts of trade liberalization specifically the less advancement in the process of reform. The Organization for Economic Co-operation and Development (OECD) is an international organization of developed countries accepting the principle of a free market economy has focused on such issues of transition economies. The efforts are .particularly cantered on designing trade policies towards multilateral trade rules, trade barriers and the economic cooperation throughout the region.
Among the measures that are recommended for transition economies are the development of an active export policy that can be done through the elimination of anti export measures and the implementation of trade programmes. Another is to establish the necessary import regulations, the avoidance of excessive dispersion of tariffs and the changes that are frequently implemented on customs tariffs (Scheele, 2006).
It can be argued indeed that the trade liberalization of transition economies remain in fragile position. Moreover, the liberalisation measures that are initiated may cause pressures and set backs to these economies. However, the achievement of trade liberalisation is likely to foster the credibility of the countries in terms of trade policies and improve the transparency as well. Ultimately, the adoption of trade rules is a challenging task for economies as strategies needs to be drawn to deal with post socialist legacies and other problems that they may encounter in the process of the transition.
The World Trade Organization (TWO)
According to Wikipedia (2006), World Trade Organization (TWO) is the only global international organization dealing with the rules of trade between nations, the heart of the organization are the TWO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments. The goal of TWO is to help producers of goods and services, exporters and importers conduct their business. The main purpose is to promote free trade by persuading countries to abolish import tariffs and other barriers. As such, it has become closely associated with globalization. (BBC News, 2005) The decisions are absolute and every member must abide by its rulings and its members are empowered by the organization to enforce its decisions by imposing trade sanctions against countries that have breached the rules. The TWO has a much broader scope than GATT. (BBC News, 2005) Whereas GATT regulated trade in merchandise goods, the TWO also covers trade in services, such as telecommunications and banking, and other issues such as intellectual property rights.
The TWO has been the focal point of criticism from people who are worried about the effects of free trade and economic globalization. Opposition to the TWO centres on four main points: (BBC News, 2005)
Ø TWO is too powerful, in that it can in effect compel sovereign states to change laws and regulations by declaring these to be in violation of free trade rules
Ø TWO is run by the rich for the rich and does not give significant weight to the problems of developing countries. For instance, the rich countries have not fully opened their markets to products from poor countries
Ø TWO is indifferent to the impact of free trade on workers’ rights, child labour, the environment and health
Ø TWO lacks democratic accountability, in that its hearings on trade disputes are closed to the public and the media
The supporters of the TWO argue that it is democratic, in that its rules were written by its member states, many of whom are democracies, who also select its leadership. They also argue that, by expanding world trade, the TWO in fact helps to raise living standards around the world.
Investment Liberalization
The Gulf war in 1991 led to a massive exodus of Arabs working in the region and it severely curtailed the flow of foreign exchange to Saudi Arabia. In the international loan market, Saudi Arabia’s credit rating plummeted. For the first time the country faced a serious prospect of defaulting on foreign loans. Assistance from the International Monetary Fund and the World Bank was sought and those institutions insisted on reforms.
Import liberalization took place over a large spectrum of goods. For example, automatic clearance of capital goods up to 25 percent of total value of plant and equipment or scores—whichever is less—was granted. Foreign equity proposals would no longer have to be tied up with a technology agreement. A Foreign Investment Promotion Board (FIB) was set up to consider large investment proposals. It could also negotiate and would give single-window clearance.
The Monopolies and Restrictive Trade Practices Act requirement that expansion of foreign ventures needed prior approval was lifted. Foreign brand names could be used by domestic industry having connections with foreign firms. Over time, the size of the negative list of exports and imports shrank. Previously there was a dividend-balancing requirement for foreign ventures, which meant that dividend payments to a foreign party over the first seven years from the date of commercial production had to be balanced by export earnings. That requirement was lifted except for 24 consumer goods industries. Many restrictions on acquisition of immovable property were removed.
In line with this, the old question, “what are the effects of multinationals” is often ill posed, since it requires a well-defined counterfactual, “as opposed to what”, in order to be meaningful.
Figures 1 and 2 present results on the direction and volume of trade in good X, comparing the results with multinationals permitted to results with multinationals suppressed.
Figure 1 shows that the liberalization of investment leads to a reversal in the direction of trade when countries differ significantly in relative endowments, but are not extremely different in size. Consider the region in the NW corner of Figure 1, for example. The exclusion of multinationals in this region means that production is primarily by type-nn firms, headquartered and producing in the skilled-labour-abundant country h. Relative endowments are sufficiently unequal that the price of skilled labour is significantly less in country h and the price of unskilled labour is significantly less in country. Liberalization of investment leads to a regime shift from primarily type-nn firms to primarily type-oh firms. Headquarters are concentrated almost entirely in country h, but enough production is shifted to country f that in the new equilibrium the direction of trade in X is reversed.
The trade-reversal result may be of some importance to policy issues in the high-income developed countries. Occasionally, “competitiveness” gets defined in terms of trade flows, with goods being defined as “high tech” in terms of their overall factor intensities or by their R&D intensities in particular. Figure 1 notes that investment liberalization may lead the skilled-labour-abundant country to import instead of export X, thereby creating a worrying loss of competitiveness. But it is hopefully clear from this model that this is an inappropriate and completely misleading conclusion. The R&D jobs, which are the source of defining X as high tech in the first place, in fact become more concentrated in country h. A more disaggregated view of production indeed establishes that country h is more specialized in high tech production. We shall return to this point in the next section of the chapter in discussing factor prices.
There is some general presumption in the theory of the multinational and indeed in all of trade theory that trade and investment are generally substitutes. Substitutes and complements can be defined in several different ways, but one of interest here is with respect to the volume of trade. Trade and investment can be defined as substitutes if investment liberalization reduces the volume of trade or vice versa. Figure 3 presents results on the effect of liberalizing investment on the volume of trade in X. This is a composite diagram for several levels of trade costs as in the case of Figure 2. The result is that investment liberalization decreases the volume of trade (or leaves it constant) over much of parameter space. However, trade and investment are complements when the skilled-labour-abundant country is also the small country, but not extremely so.
Consider, for example, the hatched area in the Western region of Figure 2. Note in particular that this region overlaps but is not identical to the region of trade reversal in Figure 1. This region of complementarily in the trade-volume sense is explained by the fact that it is a region of relatively low-trade volume in the absence of multinationals. This is in turn explained by the fact that the two sources of comparative advantage in the absence of multinationals pull trade in opposite directions. Country h is small but skilled-labour abundant in the Western hatched region of Figure 2, and we noted earlier that both size and skilled-labour abundance are sources of comparative advantage in X. In the hatched region, country h has a source of comparative advantage in X from its relative factor endowment, but a source of comparative disadvantage in X from its small size. Indeed, there is a locus of points in both hatched regions (not shown) where the volume of trade in X and Y is zero in the absence of multinationals: the size and relative endowment differences exactly cancel one another (Marcuse et al., 1996).
The hatched regions in Figures 1 and 2 may have some relevance to small, skilled-labour abundant countries such as Saudi Arabia. In particular, investment liberalization (generally in the rest of the world and not necessarily, for example, in Saudi Arabia) may reverse the direction of trade in some supposedly “high-tech” goods, and may increase the volume of trade. Neither phenomenon is by itself any cause for concern and they represent only a geographic rearrangement of activities by comparative advantage due to the fragmentation permitted by liberalization.
Remarks on Trade and Investment Policies
The apparent globalization of the market paved the way for the popular development of international trade. Indeed, countries are becoming more open to possibilities that will cater to the needs of its people through equally efficient and beneficial means. Market liberalization can then be considered as a viable option for governments to cope with the growing trend of globalization. With this development, countries are able to produce their comparative advantage goods and trade them with other countries that are in need of it. In return, they can get the same goods and services which is beneficial to them as well.
This kind of strategy will result to lower prices of commodities, more employment and the increased output of the economy. Given this, it can be assumed that the trade policies are the key factors to the overall design of the economic development. While import substitution can foster industrialization, its effects are limited only to the early phase of the economic development. As evidenced from successful economies, the shift from an autarky market to free trade results to a high performing market. Moreover, trade is regarded as an impetus for economic prosperity. And for this reason, the amount and significance of international trade is increasing and recognized by most countries.
Economies that are in the transition process are adopting trade reforms in the effort to be part of the international trade and boost their economies. The undertaking will entail the reduction of barriers to trade and thus liberalizing the market. Evidently, the impact of globalization is felt all over the world and countries coping with its phase have proved to experience tremendous gains. On the other hand, less developed and developed countries are striving to compete in the international market to boost their credibility in terms of trade policy and transparency.
On the other hand, the United Nations (2003) said that over the past decade, there has been a remarkable liberalization of FID policies; as a result, FID flows have increased at a fast rate. Because FID is becoming more important in total investment, most developing countries and economies in transition are following the developed countries in removing restrictions to FID entry and operations and improving standards of treatment of foreign affiliates; however, the results have been mixed (e.g., in many cases, opening up has not led to the magnitude of FID inflows that many developing countries expected, and that even when inflows rose, the development benefits of FID were often below expectations). The reasons behind this are the main determinants of FID flow; that is, different countries have different economic factors that may predict whether or not a FID will be successful. For instance, host countries may not have the size of markets, growth rates, skills, capabilities or infrastructure that would make investment in productive capacity attractive—either for the domestic market or as export bases. Or, foreign investors may not have been well informed of the opportunities available in a host country because, e.g., host countries did not promote themselves effectively in an intensely competitive world market for FID. More seriously, the investment may not have had a substantial developmental impact on the host economy—expanding the export base, adding technology value to exports, contributing to easing balance of payment constraints, increasing local linkages, transferring technology and upgrading skills and management capabilities. (United Nations, 2003, p. 83)
Therefore, the best way of attracting and drawing benefits from FID is not always passive liberalization. Even if liberalization can help get more FID, but alone it is not enough, as attracting FID in a highly competitive market for investment now requires stronger vocational advantages and more focused efforts at promotion. Moreover, acquiring FID in technologically advanced or export-oriented activities is even more demanding. (United Nations, 2003)
On the other hand, policies are also important to retain foreign investors in a country. More important, though, is how to ensure that FID brings more benefits. Policies can induce faster upgrading of technologies and skills, raise local procurement, secure more reinvestment of profits, protect the environment and consumers and so on. They can also help counter the potential dangers of FID—say, by containing anticompetitive practices and preventing foreign affiliates from crowding out viable local firms or acting in ways that upset local sensitivities.
Free markets do not always ensure efficient and equitable outcomes, particularly in developing countries with weak markets and institutions. Hence, the need for policy intervention. The groundwork for making markets work well—sound legal systems, clear and enforceable rules of the game, responsive market institutions, a vibrant domestic enterprise sector and the like—has to be laid down by the host country government.
In short, in the real world of imperfect markets, governments have a major role, as they can influence FID in many ways with varying degrees of intervention, control and direction.
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