Determining FDI Potential:

Are National Policies and Incentives Sufficient?

Md. Ghulam Murtaza

Foreign direct investment (FDI) is increasingly becoming a preferred form of capital

flows to developing countries in recent years, as compared to other forms of capital
flows. The reasons for this are not hard to seek. In the context of the gloom and despair of
the heavy debt burden plaguing these countries, FDI promises to be the bright ray of hope
for harnessing capital flows to the country’s economic development without the pangs of
capital repayment with interest. In this context Feldstein and Razin (2000) and Sodka
(forthcoming) note that the gains to host countries can take several other forms:
• FDI allows transfer of capital and technology, which is not possible through
financial investment in goods and services.
• FDI also promotes competition in the domestic input market
• Profits generated by FDI contribute to the corporate revenue in the host country
• Operation of new ventures by FDI leads to employee learning in the host country
who learn how to manage and operate the businesses. This contributes to human
capital development of the host country.
• Profits generated by FDI contribute to tax revenues in the host country

FDI is different from other major types of external private capital flows in that it is
motivated largely by the investor’s long-term prospects for making profits in production
activities that they directly control. Foreign bank lending and portfolio investment, in
contrast, are not invested in activities controlled by banks or portfolio investors, and are
often motivated by short-term profit considerations that can be influenced by a variety of
factors—for example, interest rates—and are prone to sudden reversals (capital outflows)
if any/some of these factors turn unfavourable. Mallampally and Sauvant (1999) claim
that the importance of FDI also lies in the fact that it not only a means of transferring
technology and skills and managerial practices, but also of accessing international
marketing networks. The greater the supply and distribution links between foreign
affiliates and domestic firms, and the stronger the capabilities of domestic firms to learn
from the presence and competition from foreign firms, the more likely it is that the
qualities/attributes of FDI that enhance productivity and competition will spread.
Recent evidence
A comprehensive study by Bosworth and Collins (1999) on the effects of capital inflows
on domestic investment for 58 developing countries during 1978-1995 covering nearly all
of Asia and Latin America as well as most of Africa finds that an increase of one dollar in
capital flows is associated with about 50 cents increase in domestic investment, while the
ratio is about one-for–one between FDI and domestic investment. There is virtually little
or no impact or relationship between portfolio inflows and investment.

FDI has also proved to be resilient during financial crises. Loungani and Razin (2001)
point out that such investment was remarkably stable in East Asian countries during the
global financial crises of 1997-98 in contrast to portfolio equity and debt flows, which
were subject to large reversals during the same period.

UNCTAD, in its recent World Investment Report, asserts that FDI has the potential to
generate employment, raise productivity, transfer foreign skills and technology, enhance
exports and contribute to the long-term economic development of the world’s developing
countries. According to a recent UNCTAD report: on World Investment:
• Foreign affiliates of some 64,000 transnational corporations (TNCs) generate 53
million jobs.
• FDI is the largest source of external finance for developing countries.
• Developing countries’ inward stock of FDI in 2000 amounted to about one-third
of their GDP , compared to just 10 percent 10 percent in 1980.
• One-third of global trade is intra-firm trade.

Similarly, Mallampally and Sauvant (1999) also assert that the increase in direct
investment flows has laid the foundation for a marked expansion of international
production by TNCs, which now have an estimated $3.4 trillion invested in about

2
449,000 foreign affiliates. The value of sales by these foreign affiliates has increased
more rapidly than that of foreign trade (world exports).
National Policies and Incentives for FDI in Bangaldesh
The second half of the 1990s witnessed a surge of FDI inflows in Bangladesh, with the
major sectors attracting FDI being oil, gas and power, followed by chemical industries
and cotton and textile industries. USA, Malaysia and UK dominate the FDI scenario in
Bangladesh. However, the inflow of FDI compared to neighbouring developing countries
is below expectations. To understand why this is so, it is necessary to look into the
national policies and incentives for FDI in Bangladesh.
Like other developing countries, Bangladesh has also adopted a number of policies and
provided generous incentives to attract foreign direct investment (FDI) into the country In
According to experts, Bangladesh seems to offer perhaps the most liberal FDI regime in
South Asia. These, among others, include: tax holiday for 5 to 7 years, income tax
exemption for 15 years for the experts of foreign enterprises, protection from double
taxation, exemption from duty for importing machinery and spare parts for 100 per cent
export-oriented units, full repatriation of profit and dividend by the foreign companies,
eligibility for full working capital loans from the local banks on banker-client
relationship, option for foreign firms or joint ventures not to sell their shares through
public issues, and protection from expropriation by the state under Foreign Investment
Promotion and Protection Act of 1980. Bangladesh is also a signatory of the Multilateral
Investment Guarantee Agency insuring investors against political risk. As a member of
World Intellectual Property Organisation (WIPO) and World Association of Investment
Promotion Agencies (WAIPA) the country further safeguards the interest of foreign
investment. Standard dispute settlement procedures are followed in case there is any
dispute with the government or with any private party. If the foreign investors feel that
their rights have been violated, they can file writs with the High Courts.

However, recent trends in global FDI flows lead one to conclude that national policy
guidelines and incentives are not the main determinants of FDI. Despite the best tax
reliefs and other incentives compared to neighbouring countries, a countries’ FDI
potential may still be low, or it may be an under-performer. To understand these issues,

3
let us look into the economic determinants of FDI, the reasons for investment from the
investors’ point of view, as well as what determines the FDI potential of a country.

Economic Determinants of FDI

From an economic perspective, determinants of FDI can be grouped into resource-
oriented and market-oriented determinants. The resource-oriented determinants include
availability of raw materials, low-cost skilled/unskilled labour, technology-created or
innovation-created assets and physical infrastructure. Market-oriented determinants for
FDI inflows from the host country’s perspective generally refer to the market size and
marketability of the field products for which FDI is sought. Projects that depend on a
resource (e.g. oil and gas and mineral processing projects) often have to compete for
capital funds with similar projects proposed elsewhere to investors. Proponents of non-
resource-based projects seek the lowest cost/highest return location for their investments.
Other economic factors such as liberal industrial policy reforms, liberalization of policies
related to FDI, investment treaties with other countries for promotion and protection of
investment, incentive packages, etc. come after consideration of the factors mentioned
earlier.

FDI Story From The Other Side:

Why Foreign Firms Look Abroad

[change and shorten]

There are various theories explaining the behaviour of multinational corporations
(MNCs) in investing abroad. A summary of some of those theories may be forwarded to
explain the behaviour of MNCs.

[shorten these theories]

A transactional theory of MNE (Multinational Enterprises) has been forwarded by
Caves (1981). According to him, MNEs—which are essentially multi-plant firms—can
be grouped into three broad categories:
1. Horizontal multi-plant firms

4
 2. Vertical multi-plant firms
3. Diversified MNEs

Horizontal Integration—the “Intangible Asset” Theory

It has been empirically observed that plants in different countries under common control
of an MNE tend to have greater profitability through lower costs than if they operate
under different managements. An explanation for this behaviour is found in some
peculiar characteristic which an MNE possesses—some “intangible asset”—unique to the
firm. Such intangible asset may be in the form of a special skill—technology, know-how
—or it may be in the form of a trade mark, or special skill in marketing a product. When
an outside firm operates in a country, it is put up with costs not faced by the local firm,
such as familiarity with the environment (including language, culture, etc.), sources of
raw materials, the local firm’s way of doing things, etc. Therefore, the successful foreign
firm must have certain transactional advantages which offset the costs and place it over
local competitors.

Vertical Integration
An MNE can exist in vertical integration as well. Suppose a processing firm needs
information about future prices and available raw materials for its production plans. The
producers of that raw material may withhold that information. In such a case, the
processing firm stands to gain by vertical integration.
The presence of multinationals in the services sector such as banking or
advertising is also explained by the transactional theory. Due to long-term relationship
with its client or some other special facilities it provides, a bank may grow a “special
relationship” with its customers in a country, which lowers the costs of transactions. It
can use these techniques in other countries to derive similar advantages. Thus it goes
multinational.

Diversified MNE
Multinational firms can be divided into a third category—the diversified MNE.
According to Caves, since foreign investment is a “risky activity”, an MNE could

5
diversify its risks by investing across countries. Economic conditions are generally
uncorrelated across countries. Therefore, adverse economic conditions, government’s
policy changes, etc. could have a downward effect on investments in a country, but if
investments were spread among countries, such losses could be wholly or partially offset
by gains in another country.
Diversification among products also tends to reduce risks in a similar manner.
Investment in LDCs offers a strong case for an MNE to diversify its interest among
different products in view of the restriction posed by many LDCs on repatriation of
profits, royalties, etc.
Once a company has decided to look abroad, the next step begins: investigation.
The company sends a team to investigate the “setting” abroad. A partial listing from the
“Foreign Investments Checklist” for US business abroad includes the following:

FOREIGN INVESTMENT CHECKLIST:

Some Factors For Consideration By US Business In Exploring Investment
Abroad
1) The general political atmosphere
2) Attitude of the foreign government towards foreign investment
3) Administrative practices affecting the prospects in investment, such as
import quotas, tariffs, availability of patent/trade-mark., etc.
4) Existence of investment guarantee agreement with US
5) Government assurances regarding remittance of profits and repatriation of
capital
6) Tax rates which effect the proposed enterprise
7) Trade agreements with other countries
8) Availability of auxiliary industries
9) Extent and elements of competition
10) Extent of market
11) Availability of domestic raw materials and spare parts

6
These are the issues on which a company tries to make information available. But a little
reflection will reveal that to gather all the information is an extremely difficult time
consuming and costly affair. So it may not be practical. The company is thus faced with a
limitation which forces it to adopt these methods. First, preliminary investigation starts at
the company’s office, on the basis of readily available information, and executives are
directed to go into the country only if the company qualifies in the first three criteria
tests. Second, the high cost of obtaining information poses a barrier to investment in the
LDCs, so the willingness of a company to invest will be higher the more easily and
readily information is available. Thirdly, since a lot of information will not be covered,
the firm will stress on flexibility as a guard against uncertainty. Rigid terms offered by a
host country will refrain the firm from investing there.
At the end of investigation, it is logical to assume that the next step would be to
take the decision whether or not to invest. But this is not always so. According to Aaron
(__) decisions to invest are sometimes taken a priori, on the grounds such as commitment
to hold the market or to protect the initial investment, and investigation seeks how to
implement the decision.

UNCTAD’S FDI Performance Index

The United Nations Conference on Trade and Development (UNCTAD). conducted
analysis to provide truer measures of the performance of the countries in attracting FDI.
First, they created the FDI Performance Index by calculating the ratio between each
countries' share in global FDI to its share of global GDP. Second, they constructed the
FDI Potential Index, using a set of structural variables to assess the potential for countries
to attract FDI.

These two indices were then used to split countries into one of four categories:

• front-runner - high FDI potential and performance, consisting of developed

countries utilising their potential;
• above-potential - low FDI potential but high FDI performance;
• below-potential - high FDI potential but low FDI performance; and
• under-performer - low FDI potential and performance, consisting of developing
countries limited by poverty or instability.

7
The second and third categories are most interesting, as countries in the first and fourth
categories are performing to expectations. The second category is drawing more than
their potential warrants, while the latter group has shortcomings that are preventing their
structural FDI from being realised.

Table 6 INWARD INVESTMENT PERFORMANCE AND POTENTIAL (1999 - 2001)

High FDI Performance

Low FDI Performance

High FDI Potential

Front-runners
Includes: Canada, Germany, United Kingdom, Malaysia, New
Zealand

Below-potential
Includes: Australia, United States, China, Qatar, Japan,

Low FDI Potential

Above-potential
Includes: Albania, Brazil, Honduras, Papua New Guinea, Vietnam
Under-performers
Includes: Bangladesh, India, Iran, Nepal, Sri Lanka, Turkey

Data source: UNCTAD

Regarding Bangladesh, the UNCTAD mentions that Bangladesh has reached the 122nd
position from 133rd in the World Investment Report (WIR) index of the UNCTAD.
According to the report, Foreign Direct Investment (FDI) rose by 72 per cent in 2004
over the previous year’s figure.

Factors Determining The Inward FDI Potential Index

The Inward FDI Potential Index captures several factors (apart from market size)
expected to affect an economy´s attractiveness to foreign investors. It is an average of the
values (normalized to yield a score between zero, for the lowest scoring country, to one,
for the highest) of 12 variables (no weights are attached in the absence of a priori reasons
to select particular weights):
• GDP per capita, an indicator of the sophistication and breadth of local demand
(and of several other factors), with the expectation that higher income economies
attract relatively more FDI geared to innovative and differentiated products and
services.
• The rate of GDP growth over the previous 10 years, a proxy for expected
economic growth.

8
 • The share of exports in GDP, to capture openness and competitiveness.
• As an indicator of modern information and communication infrastructure, the
average number of telephone lines per 1,000 inhabitants and mobile telephones
per 1,000 inhabitants.
• Commercial energy use per capita, for the availability of traditional infrastructure.
• The share of R&D spending in GDP, to capture local technological capabilities.
• The share of tertiary students in the population, indicating the availability of high-
level skills.
• Country risk, a composite indicator capturing some macroeconomic and other
factors that affect the risk perception of investors. The variable is measured in
such a way that high values indicate less risk.
• The world market share in exports of natural resources, to proxy for the
availability of resources for extractive FDI.
• The world market share of imports of parts and components for automobiles and
electronic products, to capture participation in the leading TNC integrated
production systems (WIR02).
• The world market share of exports of services, to seize the importance of FDI in
the services sector that accounts for some two thirds of world FDI.
• The share of world FDI inward stock, a broad indicator of the attractiveness and
absorptive capacity for FDI, and the investment climate.

A formula for determining investment potential in Asia

[Modify write-up language]

A formula for determining investment potential in Asia is proposed by Lawrence Yeo,

founder, CEO and principal consultant of AsiaBiz Strategy. He explains the best way for
companies to gain market entry in Asia by using a formula that identifies opportunities,
explores resources and analyses core competences before making a move.

Many of our repeat Fortune 500 and global clients have regularly sought our Asia
market entry and marketing strategy advice, because Asia is so heterogeneous and
diverse.

They ask: “Is Asian Country 1’s industry X attractive? How about Asian Country
2’s industry Y?” Such randomised market selection and industry targeting is
inadvisable.

To share with our corporate readers how we advise clients to enter Asia, here is a
sneak peak inside the mind of an aspiring world-leading Asian consultancy.

We can identify and assess Asian opportunities using a simple framework that can be
easily – yet simultaneously – performed across many Asian countries at once.

9
First, we review the client’s Asia strategic intent and mission. Next we analyse the
external environments of Asian countries (legal and regulatory environment, competitive
environment, business environment, and so on) and the internal environment of the client
(key success factors, value/distribution analysis, marketing or branding audit, Asia
strategy review, and so on). And finally we formulate the appropriate Asia strategy.

Three-part formula

The strategy formula has three parts: A, B and C:

• A is identify and assess Asia opportunities;

• B is explore resources and capabilities to determine the best strategies; and
• C is analyse core competences to determine modes of entry into the Asian market.
This is followed by strategy implementation.

To help assess the attractiveness of various Asian markets and industries, we further
modify the GE-McKinsey Portfolio Analysis.

Market attractiveness

Market attractiveness has replaced market growth as the main factor of industry
attractiveness. In turn, many factors can affect market attractiveness, such as market size,
market share, market profitability, pricing trends, competitiveness intensity, entry
barriers, market segmentation, and so on.

Let’s take Singapore for example. We can use a rating scale from 1 to 5 where 1 means
very unattractive and

5 means very attractive. The model takes into account ratings for:

• GDP output

• Market growth rate over the past five years: growth is the most important
assessment factor and it takes precedence over size and other factors when
considering industry attractiveness. It is based on the historic growth of each
industry for the past five years.

• Concentration of companies within the same industry: high competitive

intensity translates to lesser profit shared among players, hence lowering
attractiveness of the industry.

• Product sales nature: this is defined as the dependency of sales of

products/services in the specific industry on the changes in the business
environment.

10
 • Government support: the Singapore government plays an active role in
supporting Singapore’s business; therefore government support is a crucial factor
for evaluating industry attractiveness.

Here, our analysis shows that Singapore’s industries, in order of descending attraction,
are:

• High attractiveness: wholesale and retail; transport, logistics and

communication; business/ commercial/professional; IT and e-commerce; and
other services.

• Mid attractiveness: food, beverages and tobacco; electronic products and

components; other manufacturing sectors and financial services.

• Low attractiveness: wearing apparel; footwear and leather; publishing and

printing; construction and engineering; and hotels and restaurants.

Market conditions

Also, we look at our clients’ market strength. For small and medium-sized enterprise
clients, we will look at Asian market conditions and likely Asian competitors’
countermoves and recommend using a ‘niching’ strategy, substitution strategy, free-
riding strategy and strategic alliance strategy or some combination of these.

The Asian Development Bank also points out that foreign firms are attracted to
commercially profitable and politically stable environments, and that offering incentives
is often less effective at attracting investment. A recent issue of The Asian Development
Outlook, states that FDI in developing Asia grew from $694 million in 1970 to $ 138.6
billion in 2000, before declining to $ 90.1 billion in 2002, representing a growth of 15.2
percent per year. In order to attract the huge amount of foreign direct investment pouring
into the region, economies should move away from restrictive investment regimes and
alow wholly owned subsidiaries to operate.

FDI situation Bangladesh

According to an UNCTAD report, FDI to Bangladesh averaged $7 million annually from

1990-1996, but increased to an annual average of $196.8 million from 1997-2000,
primarily due to foreign investment in Bangladesh’s energy sector. In 2001, however,
new FDI dropped 72% (to $78 million) from the previous year. In 2002 new FDI again
dropped to $52 milli0on. But in 2003 the FDI jumped to $120 million.

11
Bangladesh has, very often sent trsde delegations abroad to explore trsde opportunities as
wel as highlightopportunities for investing in Bangladesh. A number of foreign business
delegations have visited Bangladesh to explore trade and investment opportunities,
including from India, France, Turkey, Malaysia, Taiwan China, and Korea.

[Change language below]

What is the story from the other side? How do foreigners see inveetment prospects I
Bandladesh? A survey of recent reports on the issue including a recent Investment
Climate Statement on Bangaldesh by the Bureau of Economic and Business Affairs of the
US Government found the following: foreigners often find that ministries request
unnecessary licenses and permissions. Added to these difficulties are such problems as
corruption, labour militancy, poor infrastructure, inadequate commercial laws and courts,
inconsistent respect for contract sanctity, and policy instability—for example—decisions
taken by previous governments being overturned when a new government comes to
power). To a lesser extent, difficulty in attracting foreign investment also results from
Bangladesh's image as an impoverished and undeveloped country subject to frequent and
devastating natural disasters.

Imperatives for Bangladesh

Despite the overall poor investment environment, Bangladesh achieved notable success
in some fields during the past years. By the end of the last decade, growth rate of GDP
exceeded 5 percent, whereas population growth rate declined to 1.5 percent. Hence per
capita income was increasing at a rate of more than 3 percent a year. The situation is
much better than what it had been in the 1980s when GDP growth rate hardly exceeded
the population growth rate. Investment has increased to 22-23 percent of GDP. Private
investment marked a faster growth than public investment. Dependence on foreign aid
declined significantly. Sectoral composition of the economy also marked some positive
changes. Share of agriculture now declined to around 25 percent, while share of service
and industry has increased to 50 percent and 25 percent respectively. Inflation rate is very
low. Overall macroeconomic balance had been sustainable in the last decade, until the
FY2002.

3.2. Success of Bangladesh is quite remarkable in select social and economic sectors.
Bangladesh’s literacy rate has increased to more than 60 percent during the past decade.
Textile and some other manufacturing sectors registered modest success. Some of
Bangladesh’s textile sector units are using state of the art technology and are capable of
competing in the global market. Likewise, pharmaceuticals and cement industries have
experienced significant quality and capacity expansion. The country’s industrial and

To be competitive in international markets, and to upgrade its potential in the foreign

investors’ eyes, Bangladesh needs to adopt urgent plans for the short-run and the medium
–term.

12
Here a distinction has to be made regarding factors and situations which are outside the
direct control of the government and those over which it can exercise direct control and
initiative. While indices such as increase in the GDP per capita, share of exports in GDP
and increasing the share of FDI in the services sector are not under direct control of the
government, and can only be influenced indirectly by it, the government should take
immediate initiatives to develop those sectors directly under its control. such as
developing the infrastructure, specifically port infrastructure and ICT

Developing infrastructure
Developing the infrastructure particularly Chittagong port is an utmost priority for
developing FDI potential in Bangladesh. {Mention example of SINGAPORE] Chittagong
port is commercially important to Bangladesh as it handles nearly 85 percent of the
country’s exports and imports. Besides, Bangladesh is located at the centre of the South
Asia Regional Economic Co-operation (SASEC) countries, having borders with India and
Mynmar and with close proximity with land-locked countries—Nepal and Bhutan.
However, problems like outdated machinery, inadequate storage space, time-consuming
custom procedures, and hartals make it one of the costliest ports in Asia. The port is
heavily congested and ship turnaround time needs 4 to 5 days compared to 1 to 2 days in
Singapore and Bangkok. Besides, the number of export containers has not increased at a
pace matching the rate of increase in the number of feeder vessels. Container handling
costs around $600 as against $150 to $300 in neighbouring ports.It may be mentioned
here that as a measure to make the port more efficient, the Government initiated measures
such as import of gantry cranes. Four gantry cranes were commissioned at the port on
January 30, 2006 to make cargo handling more efficient. But due to inefficient
management, notably, absence of skilled operators and modern vessels, they are being
used up to only a third of their capacity According to port officials, although each of the
cranes has a capacity of handling 30 TEUs (Twenty Equivalent Units) of containers per
hour, they can hardly handle more than 10 TEUs per hour. Port users have recommended
privatization as well as corporatization of maritime ports of Bangladesh, including
Chittagong Port, to bring them in the capital market and thus make them efficient for
handling growing volumes of cargo. In keeping with thesituation, the Bangladesh
Government has decided to allow private sector participation in the port sector.
Additionally, for expediting port services, the Government may opt for leasing of
equipment for port handling and leasing of floating crafts from the private sector.

Similarly, Bangladesh Railway too is incapable of carrying and delivering the container
cargoes efficiently and timely due to poor capacity, and lack of operational efficiency.
Despite huge demand, Bangladesh Railway currently accounts for less than 15 percent of
container trans-shipment in the Dhaka-Chittagong Economic Corridor (DCEC), which
provides potential sub-regional linkages to northeastern states of India as well as Nepal
and Bhutan.
Regarding road infrastructure, although there has been a rapid expansion of road network,
there is hardly any significant trans-shipment through road transport because it cannot
handle container lorries due to capacity constraint.

13
So far as Information and Communication Technology (ICT) is concerned, the country is
at an emerging stage and lacks behind other Asian countries in comparison. However, a
mentionable initiave is that the Ministry of Science and Information &
Communication Technology, in cooperation with the public/private sector, has taken
program to produce quality professionals and skilled manpower in ICT. National ICT
Task Force decided to
introduce ICT Internship Award Programme in the country. Under this program,
graduates/
fresh graduates/post graduates in ICT subjects will be imparted training for 6-months as
internees in different IT organizations/companies for acquiring practical experience and
hands
on training. The objective of the program is to impart basic training for skill
development.

Conclusion
From the above it may be concluded that to attract FDI in a meaningfully large way , it is
important for Bangladesh to look beyond offering lucrative incentive packages and also
inculcate the criterion leading to increasing its FDI potential within a short time.

---000---

14