Foreign direct investment has surged in the 1990s

Foreign direct investment (FDI) in developing countries was $120 billion in 1997, slightly above the $119 billion of 1996 and five times the level of 1990. The ratio of FDI to GDP in developing countries jumped from 0.8 percent in 1991 to 2.0 percent in 1997. Developing countries have also increased their share of global FDI flows, from 21 percent in 1991 to an estimated 36 percent in 1997 (figure 1.6).

Why the growth of FDI inflows?

The surge in net FDI flows during the 1990s has been spurred mainly by three factors: developing countries’ liberalization of their economies, particularly privatization and the lifting of restrictions on FDI; strong growth in the GDP and trade of the major developing country recipients of FDI flows; and the falling cost and rising quality of communication and transportation services, which encouraged private corporations to shift toward more integrated global investment and production. Like trade, FDI provides an important channel for global integration and technology transfer.

Multinational corporations took advantage of the liberalization of the rules governing FDI in developing countries and the privatization of state-owned enterprises to access new markets and resources. The largest FDI source countries increased their FDI in developing countries, both in absolute amounts and as a share of total stocks. Notably, the share of developing countries in the stock of the outward FDI of the five main FDI sources—the United States, Japan, Germany, the United Kingdom, and France—increased during the 1990s in all but Japan. And in Japan the share declined only marginally in the 1990s, mainly because of its large new investments in North America. Still, more than 30 percent of Japan’s outward FDI stock remains in developing countries.

FDI concentration and low-income countries

Not all developing countries shared in the rapid growth of FDI during the 1990s. Almost three-quarters of net FDI flows to developing countries has gone to just 10 countries (table 1.8). The concentration rate remains high, but it has eased somewhat in recent years, reflecting growing access to FDI.

Table 1.8 FDI flows to the top ten recipient developing countries, 1991, 1994, and 1997
(billions of U.S. dollars)

a. Preliminary.
Source: World Bank data and staff estimates.

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Most of the top recipients of FDI are middle-income countries, reflecting their large markets and rapid growth in recent years. The only low-income countries in the top 10 in 1997 were China and India. The ratio of FDI flows to GDP has remained smaller in low-income countries (excluding China) than in middle-income countries throughout the 1990s (table 1.9). Recently, however, some low-income countries besides China and India have begun to receive large amounts of FDI. FDI flows to Vietnam have increased significantly, from about $380 million a year in 1991–93 to $1.3 billion a year in 1995–97. Some countries, such as Nigeria, have long been large recipients of FDI in natural resource sectors. But many small, poor countries (especially in Africa) receive little foreign investment, often because of an unfavorable business environment (poor policies, unstable government, civil strife, weak infrastructure, poorly trained workforce) or a small domestic market.

Table 1.9 FDI flows to developing countries by income group, 1990-97
(percentage of GDP)

a. Preliminary.
Source: World Bank data.

Moderating growth in 1997

After growing strongly for several years, FDI leveled off in 1997. Preliminary estimates indicate that net FDI flows to developing countries remained high in 1997, at $120 billion, but only slightly above the $119 billion in 1996. Still, net FDI flows continued to be the largest component of external resource flows to developing countries. The largest reversal in the upward trend occurred in East Asia and the Pacific, where flows declined 9 percent in 1997, to $53 billion (figure 1.7). FDI flows to Indonesia fell 27 percent, and flows to China fell an estimated 10 percent (in part simply a reflection of the surge in FDI in 1996 as investors sought to take advantage of preferential tax treatment that expired that year). By contrast, flows to Latin America and the Caribbean rose 10 percent, to $42 billion. Large privatization projects in infrastructure and other services (notably in Brazil), better economic performance (Mexico), ongoing liberalization measures (particularly in financial services), and strong flows into Mercosur and among its members all contributed to Latin America’s FDI performance in 1997.

During the 1990s active privatization programs in many developing countries generated a steady stream of FDI inflows, attracting some $60 billion—$15 billion in 1997 alone (figure 1.8). Brazil, Venezuela, and some other countries experienced large increases in FDI through privatization transactions in 1997, while Hungary, Peru, and others saw large declines in FDI in 1997 as privatization programs slowed or ended.

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Growth of FDI in service sectors

FDI also flowed heavily into services during the 1990s. Several countries attracted especially large shares of FDI to their service sectors (table 1.10). Japan and the United States (which account for nearly half of the stock of FDI in developing countries) both showed large shares of services in their FDI to developing countries. Services account for 58 percent of the total stock of FDI in developing countries that originates from Japanese firms, while the share of services in the stock of U.S. FDI in developing countries has nearly doubled in the past decade (figure 1.9). A similar trend is observed in most major FDI source countries, except for the United Kingdom.

Table 1.10 FDI in selected developing countries, by sector
(percentage of total stock)

Source: World Bank staff calculations based on national sources.

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Several factors have contributed to the growing importance of services in FDI flows. Developing countries are lucrative markets for multinational service providers, and many services firms need a physical presence in the market to compete effectively (UNCTAD 1996). Services have also become more attractive now that advances in communications technology allow separated-service providers (data processing, software development) to reap the cost advantages of developing countries (Allen and Morton 1994). Liberalization of FDI regimes and privatizations of service enterprises have also accelerated the rush of FDI to services. Overall, some 40 percent of the revenues generated by developing countries through privatization programs during the 1990s have been directed to services, and this share has increased rapidly in the past few years. In Brazil, the largest FDI recipient through privatization operations in 1997, roughly 70 percent of the revenues were raised in service sectors such as telecommunications, power, transport, and finance.

The rapid growth of FDI in services reflects a fundamental change in the role of the private sector in providing services. Technological changes and regulatory innovations have made it possible to open these services to market forces, thus encouraging competition, which can bring substantial benefits for consumers. Greater private investment in services can also free scarce public resources for pressing social needs. To realize these opportunities, governments will need to ensure that price and regulatory rules enable service providers to operate on a sound commercial basis.

FDI outflows during the 1990s

Between 1991 and 1996 (the latest year for which reliable numbers are available) the dollar value of FDI outflows from developing countries increased by more than three and a half times to $11.1 billion, indicating the growing integration of developing economies in world markets (table 1.11). China is not only the largest recipient among developing countries, but also the largest investor, followed by Malaysia, Chile, Brazil, Thailand, and South Africa.

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Table 1.11 FDI outflows from developing countries,1991–96
(billions of U.S. dollars)

Source: IMF balance of payments data.

Multinationals from these economies are investing predominantly in other countries in the same region. In Latin America and the Caribbean the intraregional increase in FDI is driven by increasing liberalization, new investment opportunities, proximity, and trade integration. In Argentina the stock of FDI originating from other Latin American countries accounted for 15 percent of its FDI stock in 1994, up from 11 percent in 1992.

Prospects for FDI flows

What impact the financial crisis in East Asia will have on FDI flows to developing countries in 1998 is uncertain (see chapter 2). Nevertheless, medium-term prospects remain good. FDI flows are likely to be supported by strong growth in developing countries’ output and exports, greater economic integration and globalization of production, and continued liberalization of investment rules.

Studies have consistently found a strong, positive correlation between rapid GDP growth and FDI inflows (figure 1.10), although the direction of causality is difficult to determine and may go in both directions (Lizondo 1990; Hein 1992). Developing countries’ average GDP growth rate is projected to exceed 5 percent over the next 10 years, or about twice the rate in industrial countries, indicating that developing countries are likely to continue to attract a substantial share of global FDI (World Bank 1997b).

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Trade expansion and export orientation promote FDI flows. The complementary relationship between FDI and trade flows is well established (Markusen 1983; Helpman 1984; Pearce 1993; Pfaffermayr 1996). Analysis at both the firm and the country level shows a strong positive link between foreign investment and trade flows (Eaton and Tamura 1994; Kawai and Urata 1995). World trade is projected to grow by some 7 percent annually in the coming years, a further indication of the bright prospects for FDI flows (World Bank 1997b).

Regional economic integration may induce higher foreign investment flows. Regional integration agreements can promote FDI flows by expanding markets. FDI flows tend to rise in the run-up to a regional agreement, as shown by the increase in FDI flows to Spain and Portugal in the years immediately preceding their entry into the European Union, EU experiences prior to the 1992 single market, and the rise in FDI to Mexico before NAFTA. Automobile multinationals are gearing their production to the entire Mercosur market, even though barriers to automobile trade have not yet been removed. There is one caveat, however. If regional integration results in increased distortions (high external trade barriers, market-sharing agreements between ologopolistic producers), the resulting inefficiencies could outweigh the potential benefits of FDI.

Continuing liberalization of investment rules will further encourage FDI. More than 50 countries enacted more open laws on foreign investment during the 1990s, and the number of bilateral investment treaties on the promotion and protection of foreign investment increased threefold to 1,100 (UNCTAD 1997). There have also been advances in multilateral instruments with provisions on cross-border investment. The Multilateral Agreement on Investment, under negotiation among OECD countries since May 1995, would encompass the three cornerstones of FDI rule-making: investment protection, investment liberalization, and dispute settlement (box 1.3). Recent agreement in the negotiations over trade in financial services should also encourage increased FDI inflows in the future.

Continue with Development in private capital flows

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