Investment, trade linked
The World Investment Report 1996 of the Geneva-based UN Conference on Trade and Development, besides analyzing the latest trends in foreign direct investment (FDI) across the world, devoted a great deal of attention to the interlinkages between investment and trade. The 327-page report concluded that FDI increasingly influences the size, direction and composition of world trade. But trade and trade policies in turn also exert various influences on the size, direction and composition of FDI flows.
What the conclusion clearly points out is that full understanding of trade-FDI interrelationships is essential in formulating the right policies for FDI and trade so that they support one another in terms of policy objectives and their efficient implementation. Policymakers therefore should look at trade and FDI as two sides of the same coin, meaning that trade and investment liberalization should run at the same pace.
If a country treats the two sectors separately and moves faster on trade, for example, it may not get the maximum benefits from either, because restricting FDI by multinational companies would deny the country not only capital flows but also intracompany trade, which now accounts for more than 35 percent of global trade. If a country liberalizes FDI faster than its trade, it may attract mostly second-rate, short-term oriented FDI which wants only to exploit the protected domestic market. Import-substitution industrial policies, for example, rarely attract long-term oriented investors who are really serious about transferring technology and promoting exports.
For a country like Indonesia which pursues an export-led development strategy, FDI can have big benefits in that big companies usually have developed access to the world market through their affiliates and other firms linked to them and most of them have done their own market research. But there is one vital aspect that a country should be aware of in attracting FDI. Big foreign companies always endeavor to spread activities along efficiency-oriented lines, meaning they specialize in segments of goods and service production of which the host country has comparative advantages. In that way, the competitive advantages of foreign companies can interact positively with the location advantages of the host country.
The question now is how a country should act to attract FDI. There are several key lessons -- though they are not completely new -- which can be drawn from the World Investment Report 1996. Tax incentives turn out to be of minor importance to FDI. Foreign investors are more interested in such factors as political and economic stability, consistent policies, market size, costs, skill levels, basic infrastructure and conducive regulatory regime.
The report points out that relying too much on tax incentives to woo FDI does not work in the long run, as any government can offer such incentives with the stroke of a pen. In fact, education and training as well as a conducive climate for research are seen by investors as far more important than tax incentives. These three factors are especially considered essential in the developing countries offering cheap labor as one of their comparative advantages. The rationale is that whenever rising labor costs weaken the comparative advantage offered by their host country, the investors should not have to move to other locations with lower labor costs. The investors, helped by an adequate pool of skilled manpower and a large base of research capability, can easily shift to more innovative and higher value- added activities.