Are Agencies for Attracting FDI a Trap for Voters?

Many countries have set up agencies to attract Foreign Direct Investment (FDI). Have they been successful in their goal? Or are these investment promotion agencies a trap for voters, instead of an effective mechanism?

Notably, agencies attracting FDI have become an almost necessary governmental agency. Out of 36 OECD member states in 2017, 19 (52.8%) had an autonomous public agency for foreign investment promotion. 32 out of 36 had some kind of an investment promotion agency. Additionally, the World Association of Investment Promotion agencies boasts over 100 members.

With competition for trade and investments heating up, these agencies show promise. In 15 years from 2003, the world’s FDI inflows increased by $800B. Part of this increase can be attributed to the agencies working effectively to attract FDI, as shown by research.

Agencies created to increase FDI inflows can prop up local industries and improve their financial status. The most direct impact is, of course, the higher FDI inflows the agencies work to achieve. However, secondary impacts can be just as important.

The transfer of know-how is an important benefit of foreign investments to local economies. Attracting foreign companies, which have the know-how local industries lack, can help to improve the quality of already existing operations or to help launch new industries. The automotive industry in Asia is partly developed because of the know-how transfers from foreign companies.

Foreign investments often are conducted through joint local partnerships. The partnerships with foreign companies can create easier access to funds for the local companies, compared to loans or other types of funding.

Agencies whose purpose is to attract FDI make these goals easier to achieve through targeting relevant foreign businesses and through easing the process of foreign investments.

Governmental corruption can misdirect the goals of FDI agencies. Kickbacks to local government officials for their support to foreign investments are a common problem. Autonomous governmental agencies, with lower oversight from the central government, then become easier targets for corruption.

Lack of differentiation between the valuable and harmful foreign investments is a problem with many FDI agencies. Foreign investments directed solely into low skills jobs, set up a time bomb of potential problems.

A problem occurs when investment promotion agencies only have a goal to increase foreign investments, without differentiating between long- and short-term ones. This can make economies more vulnerable to the flight of services investments. This has been often the case with services centres relocating from high to middle-income countries.

Not all countries have had negative experiences with FDI. Germany and Ireland received the highest net inflows of FDI in the EU in 2018. Have investment promotion agencies contributed to the $169B inflows into the two countries?

Ireland is a great example of how a governmental agency can support economic development. Decades-long work and a flexible approach to investments has contributed to Ireland being one of the top countries in the EU for foreign investments.

IDA (Irish Development Agency), Ireland’s foreign investment promotion agency, has played a critical role in this process. Consistent actions and adaptability to the changing economic environment, are the key reasons for IDA’s success.

However, it is doubtful whether Ireland’s investment promotion agency is the strongest factor in attracting foreign investment.

Low taxes and a good regulatory environment are far stronger incentives than any work that can be conducted by a government-affiliated agency. Moreover, out of Ireland’s over 187 thousand employed by foreign companies, 130,000 (almost 70%) employees are employed by US companies. An 8.5 percentage point difference between the corporate tax rates, and historic ties between the countries, are important pull factors for establishing operations in Ireland.

Going by the internalisation theory, the removal of competition; and the advantages firms posses in some activity, determine a firm’s decision to engage in FDI. Germany, as the top destination for FDI inflows in EU, seems to be a contrarian example. Its highly competitive economy, and a strong presence of local businesses should discourage foreign firms from investments.

High-quality investment promotion work or similar factors then should influence the decision’s of businesses to invest in Germany. However, as historic ties partly explain the large percentage of Ireland’s employees employed by US businesses, part of Germany’s FDI numbers are also explained by social ties. Opposite to Ireland’s experience, migrants to Germany from high-income countries are a positive influence on FDI flows, research finds.

Because of the influence of foreign direct investments in the economic booms of many countries, FDI inflows have been made into a political goal. This has prompted many countries not only to create investment promotion agencies, but also to give autonomy for their choices. There is data that points to the conclusion that promises of foreign investment are a powerful bait for voters. Given that, it becomes clear that higher funding and more autonomy shouldn’t always be given to the agencies.

The establishment of investment promotion agencies does not always contribute to higher foreign investment. The highly variable, and dependent on outside factors, performances of investment promotion agencies show that. As bureaucracy, and along with it, the inefficiency of governmental agencies tends to grow over time, the impact of government investment promotion agencies is bound to worsen over time.

Corruption can also make agencies working to attract foreign investments more of a bait to voters, than an effective force. Any governmental agency can easily become corrupt. Especially, if less oversight is put on it. When autonomous or semi-autonomous investment agencies are a common sighting, doubts arise on whether less control should be given to an area dealing with large financial transfers.

As a direct influence on voters, new agencies to attract FDI are also a powerful political tool. Promises of higher FDI has been found to increase voting preference for politicians, it is not unreasonable to extend the association to agencies working to attract FDI. When their mixed results, and highly variable performance is considered, high accountability is imperative for success.

Focusing on good foreign relations with other countries could be an alternative to the creation of new governmental agencies with just one goal. A favourable political climate is, after all, is one of the factors that influence a business’s decision to invest in a foreign country.

Research shows that good foreign relations do contribute to a better local response to foreign investments, and that good or bad foreign relations influence the choice to which countries foreign investments flow to.

Nevertheless, are good foreign relations all that it takes to build a better economy? The question should be whether good foreign relations create better economies, or do prospering economies contribute to good foreign relations.

If good foreign relations would be a direct way to better economic outcomes, then all it would take for poor nations to develop is to improve their foreign relations. That is not the case since the lack of infrastructure and an underdeveloped labour force are far more powerful blocks to development.

Stable and improving economic indicators of a country should push other countries to seek financial benefits. One way to get to them is through diplomatic means.

Economic growth is a positive influence on FDI flows. The link between higher development and higher FDI inflows exists. Moreover, out of the top 10 FDI host economies in 2018, the developed ones received hundreds of billions of dollars more than the developing ones.

Yet, when country-to-country agreements can take decades to ratify, diplomacy starts to look like an ineffective method for increasing economic growth. After all, even after ratification, it takes a decade to double bilateral trade after an FTA is signed.

FDI itself shouldn’t always be the goal. The development of internal industries and their players could be far more beneficial in the long-term. Yet, if investment promotion is necessary, high accountability should prevent it from turning into political bait for voters.