7:05 PM Jun 14, 1996

FDI SELECTIVITY, CONDITIONING CRUCIAL

Geneva 14 Jun (Chakravarthi Raghavan) -- Selectivity in letting in Foreign Direct Investment (FDI) by TNCs and setting conditions for their operations are crucial if developing countries to get larger social benefits, according to Dr. Sanjay Lall, Lecturer at Queen Elizabeth House, Oxford, and well-known economist.

Lall's view is in an article in Transnational Corporations, the quarterly journal of UNCTAD's Division on TNCs Corporations and Investment (DTCI).

This is probably the first time that the journal has published an article questioning some of the 'virtues' normally trumpeted about the TNCs and the benefits of liberalised FDI regimes. Articles in several of its recent issues have been by protagonists of TNCs and the need for a Multilateral Investment Agreement.

The perception that the DTCI is promoting TNC interests and advocating an open door policy to FDI and TNCs, has evoked sharp criticisms from NGOs. At UNCTAD-IX in Midrand, African NGOs in their declaration said UNCTAD's investment division "should operate within the perspectives of the former UNCTC, instead of seeing its role as servicing the interests of TNCs".

Lall's article (commissioned before UNCTAD-IX) is not addressed directly to the issue of an MIA, but deals with FDI's role in the context of industrial strategy and policies on FDI in East Asia. He refutes the view that these economies, in their industrialization and development strategies, followed practically free-trade, open-door policies to FDI and brings out that these countries pursued an interventionist role.

But the case he makes out for both selectivity in allowing FDI, and state interventions to promote technological deepening within the country cannot be done if there be a multilateral investment agreement, which will provide TNCs with a right of establishment and national treatment.

In discussing international investment, Lall says two broad inter-related policy issues:

The first is whether and how much FDI to allow in i.e. whether or not to exercise selectivity in letting in TNCs. The second is, having allowed FDI, whether or not to intervene in resource allocation by TNCs, in setting conditions for their operations, and in attracting more FDI or investment of higher 'quality'.

"Both forms of intervention," Lall says, "may be desirable if there is a perceived divergence between private and social returns from TNC activity in free markets. The first set of issues is determined by the costs and benefits of FDI to developing host countries as compared to alternative ways of accessing capital, technology and skills. The second is determined by market failures in domestic (and foreign) markets which guide TNC activities and which may be altered to obtain larger social benefits for the host economy."

International investments and the existence of TNCs is due to failures in the markets that prevents them from gaining ownership advantages for their intangible assets.

"The essence of transnationlization is the internalization of imperfect intermediate markets ... As long as the internalized markets of TNCs are efficient, not just for the firm, but also for host economies, there can be no divergence between private and social interests. If, however, there is such divergence, the imposition of (privately efficient) internalized markets by TNCs may not always be beneficial for the host economy."

TNCs, Lall notes, are among the most powerful means available for transferring modern technologies to developing countries and overcoming obstacles to their utilization. By their very large internal markets for capital, skills, technology and information, they face fewer market failures than local firms. In most circumstances, therefore, there is no reason to place restrictions on their entry. Since they are at the forefront of innovation, their presence can only benefit local productivity and competitiveness.

What case is there then for exercising selectivity on FDI ?

First, there is an important distinction between the transfer and utilization of production technologies and the transfer and development of more complex design, development and innovative capabilities.

But innovative activity by TNCs tends to be concentrated in a few developed countries -- because of the location of management and decision-making centres, availability of advanced and specialized technical skills, large local markets, linkages with established suppliers and buyers, closeness to advanced S & T institutions and proximity to central decision-making.

The upgrading of capabilities in developing countries to the levels needed for high-level technological activity generally involves high learning and other costs which foreign investment tend to be unwilling to undertake. In developing countries, the TNCs may hold back the development of innovative capabilities while enhancing production capabilities. It is mainly the more advanced industrial countries that can attract and fully benefit from the transfer of innovative capabilities.

Second, the development of high level capabilities in local firms may be more beneficial for technological diffusion than a similar development within TNC affiliates. This would be the case where technological development by local firms leads to a greater spillover of benefits and linkages to local suppliers and institutions within the host economy.

Finally, a strong TNC presence in an industry, while stimulating local competitors to be more efficient in their production, can inhibit them from deepening their technological capabilities... local firms exposed to full TNC competition may prefer to import foreign technologies proven and 'ready-made' from overseas rather than invest in their own research and development capabilities.

The deepening of local technological capabilities, Lall says, is not an argument for wholesale exclusion of FDI. On the contrary, it suggests a need for selectivity only in activities and at times when technological development is feasible and desirable.

Where the host economy is not capable of economical technological deepening, or where the technology is so closely held or advanced that local development is not possible, a reliance on FDI may be unavoidable.

In some cases technological deepening could be achieved, not by keeping out TNCs, but by inviting them in and influencing their activities.

If some interventions are needed to speed up technological development, there may be two broad strategies for such intervention.

The first would be to increase dependence on FDI, but also induce the TNCs -- by a mixture of incentives, rules and negotiations as well as investments in local skills and institutions, to enter into activities with more complex technologies, upgrade local technological capabilities within given activities, establish closer linkages with local technology institutions and set up local R & D units.

The second would be to adopt a more independent strategy of restricting technology import via FDI and promoting it in 'externalized' forms -- such as licensing, joint ventures or other means, in which local firms retain control and invest in deepening and extending their technological capabilities in circumstances where this is warranted.

Local ownership or control per se would not ensure deeper innovative capabilities develop. Local firms may remain passively dependent on imports of foreign technology and skills.

The development of deeper capabilities requires other complementary interventions to ensure that incentives exist for local firms to invest in such risky activity, the necessary skills and information are available, and capital markets are able and willing to finance the process, or local firms are promoted to a size that enables them to internalize capital and other relevant markets.

The choice between FDI and nationally-led strategy of technological development depends on a country's political economy - some countries are committed to open FDI policies, others lack the tools of intervention or local entrepreneurship - and on the size and spread of the industrial sector.

Market deficiencies, Lall says, may make it necessary to introduce measures to strengthen a country's attractiveness to TNCs, guide TNC entry into activities conducive to industrial upgrading, and develop factor markets in ways that lead to upgrading in the quality of FDI.

Given the basic pre-conditions for attracting foreign investors, governments may have to promote their countries in international investment markets and target their promotion to particular home countries or TNCs.

In responding to market forces, foreign investors would focus on activities that exploit a host country's given competitive advantage rather than those that could be developed with some additional effort. The upgrading of investment activities would thus await accumulation of production factors and reflection of this in relative factor prices. And countries with high wages and rising stocks of capital may not attract complex and high-skill industrial investments.

Intervention could be used to promote upgrading of TNC activities from simple, labour-intensive and low-technology to more complex and demanding ones, by guiding foreign entry or providing strong incentives. International could also be needed to deepen technological activities in host countries - from those needed for final assembly and processing to those needed for adaptation, design, development and finally innovation.

Such intervention may involve inducing TNCs to strengthen local technology activities, to establish closer links with local technology institutions and to set up in-house research and development activities or to strengthen the base of local supplier firms, technical skills and technology institutions or a mixture of both.

This, Lall stresses, is not merely a hypothetical policy issue. It guided policy makers in East Asia where the need for selective and other intervention to promote industrialization was widely recognized.

Each government perceived different policy needs in line with its own strategy, identifying different market failures and adopting different solutions. Some chose to intervene very little either in the entry or subsequent activities of the TNCs. Some chose to rely heavily on FDI but intervene in TNC operations. And some chose to reduce reliance on FDI and intervene extensively to promote local enterprise and indigenous technological capabilities. All this took place in a common setting of strong export-orientation, private-sector primacy, well managed and strong capable governments.

Explaining the varying strategies followed by Hong Kong, South Korea, Taiwan and Singapore, Lall points out that laissez-faire policies to FDI were not the norm in East Asia, and there were sound economic reasons for the kinds of intervention in investment flows.

These may or may not have involved restricting TNC entry - the normal sense in which FDI interventions are regarded. But they always required functional intervention to strengthen basic factor markets and institutions, in order to upgrade competitiveness and quality of FDI. This was the kind of intervention that Hong Kong pursued.

In other economies, they entailed extensive selective interventions, aimed at upgrading technologies and technological capabilities: the "target and guide" strategy of Singapore and the "restrict and exploit" strategy of Korea and Taiwan.

Korea, with stronger ambitions to enter heavy and high-technology industry and set up its own giant firms with ownership advantages to rival those of TNCs of the developed world, mounted stronger interventions than Taiwan.

There is still considerable debate about effects of selective industrial policies in East Asia, and there remain doubts about the extent to which ability to mount such intervention is present elsewhere.

The conditions under which governments can exercise efficient intervention are not found in many developing countries. The risk of government failure is so great in some that it may be better to suffer the consequences of market failure rather than indulge in selectivity.

In such cases, governments should confine themselves to 'market friendly' interventions and entrust the custodian role to free markets in trade and investment.

"However, government capabilities are not static or given in perpetuity; they can be improved, and there are various levels of selectivity in intervention....

"As long as the development process is confronted with widespread market failures, there are good reasons that careful selective and functional interventions can speed up development. The recent swing of opinion in favour of free markets needs to be tempered with a proper consideration of the role of government. This applies to FDI as well as to other areas of industrial policy".