The linkages between Domestic Investments and FDI, and the Growth of MEDA Countries

FEM31-20 | September 2010

Title

« The linkages between Domestic Investments and FDI, and the Growth of MEDA Countries »

By

Marc Lautier, CEPN, Université Paris 13 et Gérard Duchene, Université Paris 12

Contributeurs

Youcef Benabdallah, CREAD, Algérie ; Jean-Raphael Chaponnière, CEPN, Université Paris 13, France ; Nassima Hamidouche, CREAD, Algérie ; François Moreau, CNAM, France ; Sonia Seghir, Faculté de sciences économiques et de gestion, Université El Manar, Tunisie ; Tharik Ramoun, Université Paris 12, France ; Samir Zouari, Université Paris 12, France

Note :

This document has been produced with the financial assistance of the European Union within the context of the FEMISE program. The contents of this document are the sole responsibility of the authors and can under no circumstances be regarded as reflecting the position of the European Union.

Summary :

Comparative analysis has demonstrated that the trade specialisation of MEDA countries has been stable and not sophisticated. Income growth has also been weaker in the MEDA region since the 1970. The growth and exports quality gap between MEDA and ASEAN, or Central-European countries, has often been explained by the lack of FDI inflows in the MEDA region and, thus, their limited contribution to economic progress.

While Aid and concessional loans used to account for the bulk of resource flows to developing countries (DC) a couple of decades ago, FDI is now the main source of external resource. The share of FDI in total net flows grew from 29% in 1991 to 80 % in 2008 ; meanwhile the share of official flows declined from 50 % to 3%. With few alternatives sources of foreign financing, it is not surprising that the attitudes towards inward FDI have changed over the last couple of decades. In contrast to former skepticism about whether FDI inflows should be encouraged at all, and to the frequent implementation of unfriendly policies towards Multinational Corporations (MNC), policy makers, and many scholars too, now take the beneficial effects of FDI for granted. “MNC used to be seen as the emblem of dependency; they have now become the saviors of development” (Rodrik 1999). Implementation of pro-FDI regulations has been encouraged by a body of literature, which insists on the positive role of FDI in the growth and development processes. Thus, in addition to fill the traditional investment and foreign exchange gaps, FDI can stimulate domestic investment, increase local market competition, enlarge international market access for local products, and generate other types of externalities and knowledge “spillovers”. While development strategies used to focus on State’s investments and interventions, FDI is now considered as the main source of catching-up and technological development.

FDI flows can undoubtedly promote growth. Yet, the reverse causality, from growth to international investment attraction, may also explain the correlation. MNC location decisions should be influenced by host-countries economic performances: it would be logical for MNCs to choice to invest in the more profitable economies. In this context, one of the primary focus of this research is to investigate whether domestic investment is a significant determinant of FDI in MEDA and developing countries. It differs from most existing studies notably because it analyzes the influence of domestic performance on international integration, rather than the impact of international integration on domestic performance.

The first section of the report investigates the impact of domestic investment on FDI in developing countries, using a large cross-country sample for the period 1984–2004. While the literature has provided much studies on the effects of FDI on growth and investment in host-country, very little is known about how domestic investment itself affects FDI inflows. Evidence from annual data for 68 developing countries from all regions of the world suggests that lagged domestic investment has a quantitatively significant impact on FDI inflows in the host-economy. This impact is strongest when countries keep away from under-development status. For instance, for DC with a GDP per capita above 1500 $, a one percent increase in domestic investment, as a percent of GDP on average, increases FDI as a percent of GDP by as much as 0,1 %. The correlation increases also when total FDI is replaced by greenfield or “net” FDI as the dependant variable. We conclude that domestic investment is a strong catalyst for FDI in DC. One of the main policy implications of this result is straightforward : the promotion of domestic firms investment will lead to more FDI inflows. Developing countries will benefit from measures aimed at encouraging domestic investment, and a better investment performance will efficiently stimulate FDI. The evidence suggests that active industrial policy, aimed at enhancing the profitability and the scope of domestic investments, will be effective to increase FDI inflows in the country. Furthermore, the study confirms that a FDI-attraction policy can not serve as a development strategy, because FDI flows are going to developing countries which have already a strong investment rate. Thus FDI flows where there is already a dynamic process of economic development: our evidence suggests that MNC follow economic development.

The second section of the report analyses the role of institutions on investment behaviors in MEDA and DC. While several papers have insisted on the role of domestic institutions on FDI attractiveness, their impact on domestic investors is less well known. An econometric model is built and applied to a sample of 51 emerging and developing countries to explore further this issue. A specific feature of the MEDA countries is the lack of a strong correlation between the gross investment rate and growth. Whereas the results suggest also a weaker than expected link between FDI and growth. On the contrary, the role of the quality of institutions on domestic investment is clearly confirmed.

In the third part of the report, the case of Algeria gives the opportunity to study the relationship between investment –domestic and foreign- and the revenues from oil. Different quality of institutions, or in the business climate, has explained the difference between resource-cursed and resource-blessed countries. In Algeria, the favorable terms of trade have been linked to a slow and volatile growth. The growth rate is not very high : it is close to the average of the African countries. Growth in Algeria is exogenous, mainly led by the oil sector. Public policies have neither succeed in diversifying the sectoral sources of growth, nor in stimulating FDI entry. The State’s budget comes directly from oil income and it is disconnected from the rest of the national economy. This financial independence has allowed the State to become autonomous from the national economy, the civil society and their needs. Income tax for instance are negligible in Algeria. While the government has implemented and planned several reform to liberalize domestic markets since 1988, evidences have demonstrated that there is still a strong need to improve the business climate and to stimulate investment and growth.

The last chapter gives a detailed statistical analysis of investment flows in Tunisia, both domestic and from abroad. It shows the significant increase of FDI during the recent period. They account now for 10 % of the investment total and contribute to 1/3 of exports and 1/6 of total employment. This expansion is mainly explained by the stable political and social context, combined with the improvement of the business climate and the robust economic growth.