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Multinational Enterprises in Asian Development



Multinational Enterprises in Asian Development Prema-chandra Athukorala, Professor of Economics, Research School of Pacific and Asian Studies, Australian National University, Australia

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Prema-chandra Athukorala, 2007 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data Athukorala, Prema-chandra Multinational enterprises in Asian development / Prema-chandra Athukorala. p. cm. Includes bibliographical references and index. 1. International business enterprises—Asia. 2. Asia—Economic policy. I. Title. HD2891.85.A86 2007 338.8
885—dc22 2006023098 ISBN: 978 1 84720 102 7

Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall

For my great mentor, Max Corden

Contents List of figures List of tables Preface 1

2

3

4

5

ix x xiii

Multinational enterprises and developing countries: background and preview The role of MNEs in economic development: changing perceptions Scope and preview Foreign direct investment in developing Asia: trends, patterns and prospects Policy context Trends The ‘China fear’ Industry profile Prospects: a summing up Multinational enterprises and manufacturing for export: emerging patterns and opportunities for latecomers MNEs and manufacturing for exports: a typology Evidence Concluding remarks Appendix 3.1: Data sources on MNE share in manufactured exports Product fragmentation and trade patterns in East Asia Data Trends and patterns of product fragmentation Product fragmentation and trade patterns Conclusion and inferences Multinational firms in crisis and recovery: lessons from the 1997–98 Asian crisis Analytical context Capital flows during the crisis Role of MNE affiliates in adjustment and recovery Concluding remarks vii

1 3 6 12 13 26 35 39 41 45 47 54 67 70 72 74 75 84 97 100 101 102 112 119

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6

7

8

9

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Capital inflows and the real exchange rate: foreign direct investment versus short-term capital Trends and patterns of capital inflow Real exchange rate–capital flow nexus: a first look Real exchange rate–capital flow nexus: empirical analysis Conclusion Appendix 6.1: The Australian model Appendix 6.2: Measurement of the real exchange rate Trade orientation and productivity gains from international production Analytical framework Data Productivity patterns Determinants of productivity Conclusion and policy inferences Appendix 7.1: Measurement of total factor productivity growth Multinational enterprises and the globalization of R&D: a study of US-based firms Theoretical framework Trends and patterns of R&D internationalization Determinants of R&D intensity Conclusion Appendix 8.1: Country coverage, variable definition and data sources and supplementary regression results Multinational firms and factor proportions in manufacturing: does parentage matter? Foreign direct investment in Sri Lankan manufacturing Methodology and data Results Conclusion Foreign direct investment in economic transition: the experience of Vietnam Investment climate Trends and patterns of FDI Economic impact Conclusions and policy inferences Appendix 10.1: Export processing zones in Vietnam

References Index

121 124 128 133 140 143 145 147 149 153 156 156 161 166 168 169 171 180 191 194 198 200 208 211 217 219 220 225 234 246 248 250 273

Figures 2.1

FDI inflows to developing countries and developing Asia, 1980–2004 3.1 Share of MNE affiliates and world market share in manufactured exports in selected Asian countries 4.1 World trade in parts and components, 1992–2003 4.2 Parts and components exports by major country groups, 1992–2003 5.1 Net capital flows to Indonesia, Korea, Malaysia, the Philippines and Thailand, 1996q1–2002q1 6.1 Net private capital flows to Asia and Latin America 6.2 Net capital inflows and the real exchange rate for selected Asian and Latin American countries, 1985–2000 6.A1 Capital inflows, the real exchange rate and economic adjustment in a small open economy 9.1 Foreign direct investment in Sri Lanka: value in US$ million and as a percentage of gross domestic fixed capital formation 10.1 Foreign direct investment in Vietnam, 1990–2005

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32 57 77 78 106 125 129 144

201 228

Tables 2.1 2.2

Foreign direct investment inflows, 1980–2004 Foreign direct investment inflows as a percentage of gross domestic fixed capital formation, 1980–2004 2.3 FDI flows to China as reported by China and by investing economies, 2000–03 2.4 US direct investment in selected Asian countries, 1994–2002 3.1 A typology of MNE participation in manufacturing for newcomer exporting countries 3.2 MNE affiliates and manufactured exports from selected developing Asian countries: MNE share in total manufactured exports and selected export performance indicators 3.3 Determinants of export market penetration: regression results 3.A1 Data sources on MNE share in manufactured exports 4.1 World trade in parts and components, 1992–2003 4.2 Annual compensation per worker in manufacturing, 1990–98 4.3 Parts and components in manufacturing trade 4.4 Percentage composition of parts and components exports and imports by three-digit SITC categories, 2003 4.5 Direction of parts and components trade 4.6 Share of parts and components content in regional manufacturing trade flows 4.7 Intra-regional trade shares: total manufacturing, parts and components, and final trade, 1992, 1993 and 2003 5.1 Capital flows in Asian crisis countries, 1990–2000 5.2 Percentage change in net capital flows during 1997–98 over 1995–96 5.3 Mergers and acquisitions by foreign firms in Asian crisis countries, 1990–2001, announced value 5.4 US direct investment in Asian crisis countries, 1994–2001 (US$ million) x

27 30 36 38 48

55 66 70 76 80 81 85 89 94

96 104 109 109 111

Tables

Asian crisis countries: foreign direct investment as a percentage of gross domestic investment, 1990–2001 5.6 Exports by majority-owned affiliates of US MNEs as a percentage of total host-country exports in East Asia, 1995–98 5.7 Exports by majority-owned affiliates of US MNEs as a percentage of total sales in East Asia, 1995–98 5.8 Share of employment in US affiliates in total manufacturing employment 5.9 MNE presence and post-crisis performance in Malaysian manufacturing 6.1 Net capital inflows to selected Asian and Latin American countries: 1985–99 6.2 Capital inflow episodes of selected Asian and Latin American countries 6.3 Determinants of the real exchange rate in selected Asian and Latin American countries 6.4 Change in explanatory variables during the capital inflow boom compared with the mean level for the sample period 7.1 Overseas operations of US manufacturing MNEs: estimates of productivity and related indicators 7.2 Determinants of productivity growth: regression results with trade orientation measured by export–sales ratio 7.3 Correlation matrix 7.4 Determinants of productivity growth: regression results with trade orientation measured by Sachs–Warner index and black market premium 8.1 R&D internationalization of US MNEs during 1966–2001 8.2 Industry distribution of R&D expenditure of selected countries, 1990–2001 8.3 Overseas affiliates of US manufacturing MNEs: FDI stock, sales, R&D expenditure and R&D–sales ratio by country/region 8.4 Percentage share of R&D expenditure of US MNE affiliates in total R&D expenditure in host countries 8.5 Determinants of R&D intensity: random-effect GLS estimates 8.6 Summary data on variables used in the regression analysis 8.A1 Country coverage 8.A2 Variable definition and data sources 8.A3 Determinants of R&D intensity: alternative regression results

xi

5.5

112

114 114 115 117 127 133 137 138 157 159 160

162 172 174

175 179 187 188 194 195 197

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9.1 9.2 9.3 9.4 9.5 9.6 9.7 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 10.10 10.11

Multinational enterprises in Asian development



203 205 207 212 213 215 216 224 225 226 232 233 235 236 237 241 242 244

Preface Both scholarly and policy interest in the role of multinational enterprises (MNEs) in the contemporary world economy has burgeoned in recent years against a backdrop of growing economic integration of national economies into the global economic system. The data chronicling their global operations have become far more extensive, and the scientific literature, both theoretical and empirical, dissecting their activities has grown much richer. However, the implications of the operations of MNEs for economic development in host developing countries remain elusive. There are many unresolved issues relating to designing policies to regulate and monitor the entry and operations of MNEs as part of the overall national development endeavour. This book aims to fill this gap in the literature by examining some issues central to this policy debate in the light of the experiences of developing countries in Asia. Developing Asia provides a valuable laboratory for the study of these issues, given the long-standing presence of MNEs in many of these countries and the diversity among countries in terms of the stage of development and the timing of policy transition towards greater receptivity to MNE involvement in the national economies. The book begins with an overview chapter which traces the evolution of post-war thinking and paradigm shifts relating to the role of MNEs and foreign direct investment in economic development and describes the structure and contents of the ensuing chapters. The next chapter gives a broadbrush picture of policy reforms and the investment climate in developing Asian economies and examines, from a comparative regional and global perspective, their experiences as hosts to MNEs as reflected in foreign direct investment inflows over the past three decades. The rest of the book is structured thematically, with each chapter providing a self-contained treatment of a selected theme of the contemporary debate on harnessing MNE participation in national development. The issues covered in the chapters include the role of MNEs in manufacturing export expansion; the ongoing process of international product fragmentation and its implications for trade patterns and global integration of developing countries; global research and development activities of MNEs; the relative stability of foreign direct investment compared with other forms of capital flows in the context of international financial crises, and the implications of the xiii

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operations of multinational enterprises for the recovery process; the implications of MNE presence for productivity growth in manufacturing, and the role of host country trade policy in conditioning the outcome; and the role of foreign direct investment in economic transition in former centrally planned economies (based on the experience of Vietnam). The core (thematic) chapters follow a common structure encompassing the state of the debate, relevant theory, methodology and data sources, and policy implications of the results, with extensive referencing to the related literature for those desiring to pursue the individual topics further. Two key concerns that guide the empirical analysis throughout are the interconnection between theory and practice and the choice of analytical procedures and tools with a view to getting the maximum out of the available (limited) data. I believe that the book will be of interest to a broad audience, consisting of students, professional economists and policy makers. The economics of MNEs is a popular subject in advanced undergraduate (college) and graduate curricula, in its own right or as a major component of courses in international economics, development economics and international business. While there are a number of excellent textbooks on the subject, there is a dearth of empirical evidence and case study material to supplement the analytics. This book aims to fill the gap. Apart from this pedagogical value, the book will also serve as a valuable reference source for professional economists, and policy makers in developing countries and international development agencies in broadening their understanding of the role of MNEs as an integral part of the international dimensions of development policy. The reader will find this book to be unique amongst the few available policy-oriented books in this area, not only in terms of the subject coverage but also in terms of the effort made to draw upon a variety of hitherto unexploited data sources in studying the issues at hand. Chapters 4, 5, 6, 7 and 9 draw upon my sole or joint contributions to the following journals: Asian Economic Papers (MIT Press); the Australian Economic History Review (Blackwell); The World Economy (Blackwell); Transnational Corporations (United Nations); and the Oxford Bulletin of Economics and Statistics (Blackwell). I thank the publishers for granting copyright clearance. The published material is incorporated in the book with considerable modification, rewriting and expansion in order to avoid overlap as well as to update the data and the literature coverage. It is a pleasure to thank everyone who helped me in this endeavour. Most importantly, I am grateful to my co-authors, Sarath Rajapatirana, Satish Chand and Sisira Jayasuriya, both for fruitful research collaboration over the years and for permission to make use of material from our joint papers in Chapters 6, 7 and 9 respectively. I would also like to express profound gratitude to Peter Drysdale, Chris Findley, Ross Garnaut, Hal Hill, Vijay

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Joshi, Chris Manning, Ross McLeod, Xin Meng, Kunal Sen and Peter Warr for valuable comments on and constructive criticism of various versions of one or more of the individual chapters. A special vote of thanks goes to Max Corden, James Riedel and Tony Thirlwall, and also to Sarath Rajapatirana for valuable advice and encouragement over many years. I have benefited from research assistance provided at various stages by my PhD students, Juthathip Jongwanich, Archanun Kohpaiboon, Nobuaki Yamashita and Tran Quang Tien, who always performed beyond the call of duty. To them, I express my profound appreciation. Edward Elgar Publishing Ltd has been unfailingly helpful; I am indebted to Edward Elgar for nudging me into this project, and to Alexandra O’Connell, Suzanne Mursell and the staff for converting a complicated, unwieldy manuscript into a beautiful book. Finally, my family – Soma, Chintana and Chaturica – deserve my warmest thanks for love, forbearance and unwavering support without which this task would never have been completed. Chintana and Chaturica also deserve thanks for help with preparing the manuscript. Chandra Athukorala Australian National University June 2006

1. Multinational enterprises and developing countries: background and preview Multinational enterprises (MNEs)1 are a major force in the evolving process of economic globalization which is encapsulating and reconfiguring the nature of global economic space. By the early 1970s, many US-based enterprises had already gone some way toward creating a global network, when European and Japanese firms began to take their place alongside the US firms. The global spread of companies from relatively high-income developing countries, in particular the East Asian newly industrializing countries, was an even more recent phenomenon, dating from about the mid-1970s. Today, the world is blanketed with affiliates of firms head-quartered in many different countries. Activities of MNEs have expanded from mining and petroleum industries, the traditional mainstay of their global operations, to manufacturing and services. They have established a strong and ever increasing presence in almost every country, including the former centrally planned economies in Asia and Central and Eastern Europe, linking factor and product markets across the globe. Global operations of MNEs are therefore a key factor that impinges on the designing of national development policy in the context of a rapidly globalizing world economy. Foreign direct investment (FDI)2 – the only ubiquitous quantitative indicator of the scale of MNE activity – grew dramatically from an average annual level of US$59 billion during 1980–84 to US$844 billion during 2000–04, recording an annual compound growth rate of about 5 per cent (compared with a 3.8 per cent rate of growth in world merchandise trade).3 The share of FDI in total private capital flows increased from 22 per cent to 32 per cent between these time points. The bulk of total world FDI inflows is absorbed by developed countries, with the share of developing countries (including transition economies) hovering around an average annual level of 28 per cent during 1980–2004. However, FDI inflows account for a much larger and increasing share of gross domestic fixed capital formation in developing countries compared with developed countries (8.5 per cent and 4.4 per cent respectively during 1980–2004). 1

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Moreover, from about the late 1980s, FDI has continued to be the largest single source of total external finance (private capital inflows
official development assistance (ODA)) for developing countries. During 2000–04, FDI accounted for more than half of total external resource flows to these countries and was considerably larger than ODA.4 The scale of MNE activity is obviously better gauged by direct indicators of their performance, such as production, sales or employment, rather than by looking just at FDI.5 However, such performance indicators are unavailable for about half or more of the affiliates of MNEs, because most countries do not collect information on what their firms do outside their national boundaries (Lipsey 2004). According to available rough estimates (made by extrapolating the available data to the global level), production in foreign affiliates of MNEs (that is, production in enterprises located outside the country of residence of their parent companies) increased persistently from about 4 per cent of world output (GDP) in 1982 to about 10 per cent in 2004, and their share in world merchandise trade rose from 32 per cent to 39 per cent. Total employment in foreign affiliates recorded a three-fold increase (from 19.6 million to 57.4 million) between 1982 and 2003 (UNCTAD 2005, Table 1.3). Data on FDI (or direct performance indicators) tell only part of the story of the impact of multinational firms on host economies. This is because ‘the modern multinational company is primarily a vehicle for the transfer of entrepreneurial talent rather than financial resources’ (Dunning 1992, p. 321). The decision of a firm to set up an affiliate in a given country is underpinned by the desire to reap benefits from its specific advantages (in the form of technology, managerial expertise, marketing know-how and so on), which cannot be effectively leased or sold through ‘arm’s-length’ market dealings with unrelated firms. Thus multinational affiliates bring along with them some firm-specific knowledge in the form of technology and managerial expertise that cannot be effectively leased or purchased on the market by the host country. As part of the parent company’s global network, they also have marketing channels in place and possess experience and expertise in product development and international marketing. Given these firm-specific advantages, MNE affiliates have the potential to contribute directly to the economic growth of the host country through improvement in productivity. In addition to this direct effect, the presence of foreign firms can also impact on the overall growth performance of the host economy through ‘spillover effects’ (positive or negative) on local firms. On the positive side, foreign firms can act as conduits of new technology, managerial practices and marketing know-how for local firms, either through pure demonstration effect or as an integral part of their local operations through employee training and direct dealing with local firms in

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procuring material inputs and services. Technology diffusion may occur through labour turnover as domestic employees move from foreign to domestic firms. On the negative side, MNE affiliates could well make use of their business prowess to thwart domestic entrepreneurial initiatives through ‘unfair’ competition. They could attract scarce trained domestic manpower at the expense of local firms by paying higher wages and providing better working conductions (Caves 1996, Barba Navaretti and Venables 2004, Blomström and Kokko 1998). A given degree of MNE presence as usually measured by FDI relative to the size of the economy is, however, unlikely to have the same impact on economic performance in all host countries. There is ample theoretical reasoning backed by empirical evidence that the national gains from MNE presence are conditioned by the nature of the domestic policy regime and various resource-endowment related factors such as the stage of human capital development and entrepreneurial advancement.6 Relating to the policy regime, a country with an outward-oriented policy regime has the potential to reap greater benefits than a country whose policy regime has a policy bias in favour of import-substitution production. This is because, in contrast to an import-substitution regime, an export-oriented regime generally encourages MNE activities where the host country has comparative advantages in international production. The growth effects of MNE presence may also depend on the host country’s policies impacting on the performance of domestic private enterprises. A policy regime which discriminates against domestic entrepreneurial initiatives in favour of stateowned enterprises, for example, could obstruct spillover benefits from multinational affiliates. As regards the domestic resource endowment, a host country which is at an advanced stage of human capital and entrepreneurial development is better placed to reap technological spillovers from MNE presence than a country with a lower ranking in terms of these preconditions. Spillovers also depend to a large extent on the effort of local firms to invest in skill development and research and development (R&D) activities.

THE ROLE OF MNES IN ECONOMIC DEVELOPMENT: CHANGING PERCEPTIONS During the first decades or so of the post-war period, there was a general consensus in the economic profession that FDI (or private foreign investment (PFI), as it was called then) was beneficial to developing countries in economic take-off as a complement to foreign aid. Foreign aid could do more to help as far as economic and social overheads were concerned, but

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PFI was more appropriate in mining and manufacturing, areas in which governments had little or no expertise. In these areas, PFI was regarded as the largest potential source of capital and other complementary resources – entrepreneurship, technology, management and marketing – lacking in developing countries. Thus the policy advocacy of the time encouraged developing countries to provide a hospitable climate for foreign investment, not only through removing/reducing regulatory barriers but often through such policy inducements as tax holidays and subsidies (Little 1982, Chapter 8). This receptive attitude towards FDI was rather short lived, however. From about the early 1960s the relationship between the MNEs and the national state became increasingly hostile against the backdrop of the wave of independence movements and the struggle for social and economic transformation in the new nations emerging from the colonial era. The governments of developing countries began to be increasingly concerned with the ‘external’ economic and political effects of foreign investment rather than with its measurable effects on economic growth. This dramatic shift in perception was partly based on various highly published cases of ‘ruthless’ exploitation of natural resources by MNEs and the unacceptable intervention of some MNEs in the political affairs of some countries (Vernon 1971, 1977, 2000). There also emerged a growing scepticism in the economic profession of the day about the impact of FDI, with an increasing number of economists portraying foreign direct investment as basically an exploitative relationship which set developing countries on a dead-end route of ‘dependent capitalism’. In line with the basic thrust of development thinking of the day, which considered the external resource gap as the prime constraint on economic take-off in developing countries, the economic debate on FDI began to be dominated by the fear that MNEs might worsen countries’ balance of payments. A series of studies commissioned by UNCTAD on the subject in the early 1970s (the main findings of which were subsequently published in Lall and Streeten 1977) forcefully argued that MNEs contribute to a worsening balance of payments position of host countries through transfer pricing between affiliates located in different countries; by introducing inappropriate, import-intensive technology; and by financing investment from funds raised locally rather than through actual direct foreign investment, while not generating enough foreign exchange earnings (through exporting) to counterbalance their profit remittances. These studies, which spawned a series of supporting studies by various individual authors,7 provided the rationale for an increasingly restrictive and selective approach to foreign investment approval and monitoring of the activities of MNE affiliates in host countries, including the imposition of export

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performance requirements and restrictions on profit remittances, and setting up of institutional mechanisms for monitoring pricing practices. Another school of thought that held sway (particularly in Latin America) during this period argued that FDI helps to create local initiatives in the early stages of development but later discourages them by suppressing local technological development and growth of indigenous enterprises (Hirschman 1969). The real national development challenge for host countries to MNEs, according to this view, was ‘how to divest [not how to promote] FDI’. The hostile attitude towards MNEs based on these political and economic considerations triggered a wave of nationalizations of MNE affiliates in many countries. Home countries of MNEs, the USA in particular, responded to these nationalizations with various retaliatory actions, compounding the initial host-country suspicion of MNEs as instruments of imperialism. The cumulative outcome was a massive contraction in foreign investment in many countries in the 1960s and 1970s (Vernon 2000, pp. 67–70). From about the late 1970s, the interaction between the developing countries and MNEs gradually shifted from being largely adversarial and confrontational to being conciliatory and cooperative. Several factors accounted for this change in attitude. First, a growing body of scholarly research served to tone down the strongest of the criticisms of MNEs in developing countries. In particular, the new evidence served to demonstrate that the case against MNEs had greatly exaggerated the difference between indigenous and foreign enterprises and that both types of firms may do economic harm in overprotected markets. MNEs could be effectively engaged as partners, rather than protagonists, in the national wealth-creation process by adopting market-oriented policies which promote efficient operation of both foreign-owned and domestic enterprises. There was indeed mounting evidence that some developing countries which had adopted very liberal policies on MNEs, with no regulation on transfer-pricing and relatively attractive tax rates, did not seem to suffer from the problem. Furthermore, an increasing number of well-reasoned analyses convincingly demonstrated that the early anxiety about transfer-pricing practices of MNEs had been underpinned by misconceptions about what the phenomenon was all about. As a key proponent of the early view subsequently admitted, ‘most of the evidence [of transfer-pricing] came from one industry, pharmaceuticals, and involved the comparison of prices charged on intra-firm transactions with what would be charged by a non-patent observing imitator . . . [and this comparison ignored the fact that] . . . an innovative firm had to charge much more than an imitating one’ (Lall 1983b, p. 13). Secondly, the palpable ideological shift in development thinking away from import-substitution to export-oriented development strategy was

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naturally accompanied by a greater receptivity to MNE participation in domestic production. In this policy transition, the role of MNEs in the introduction of new industries or new products to the host country and the tighter linking of the host country to the world trading system began to attract increased policy attention. This ideological shift received further impetus in the 1990s from the demise of central planning and widespread renaissance of the market economy as the dominant socio-institutional system for resource allocation. Thirdly, the virtual disappearance of commercial bank lending to developing countries in the early 1980s compelled many countries to look for alternative sources of new capital. In a context where official development assistance had persistently lagged behind announced aid commitments as well as the investment needs of the recipient countries, liberalization of restrictions on incoming foreign investment turned out to be a natural policy choice. Finally, the passage of time had itself soothed some of the greatest fears about MNEs and both host countries and multinationals have come some way during the past quarter century in accommodating themselves to the existence of one another. In a related new development, labour unions and other non-governmental organizations in home countries have been learning to use the multinationals as levers for the achievement of new goals, such as preventing international pollution, promoting religious freedom and discouraging the use of child labour. These developments have begun to play an important role in reducing the risk of conflict between MNEs and host countries (Vernon 2000).

SCOPE AND PREVIEW The great confrontation extending over the developing world between the national state and the MNEs is certainly in the past. It is now widely accepted that MNEs have the potential to play an important role in economic development, not only by bringing in new capital but also, and more importantly, by referring modern technology, market know-how and modern management practices to developing countries. This broader consensus by no means implies that the governments in host countries have no role in regulating MNE entry to their countries or in regulating the activities of MNE affiliates. It has merely brought about a shift in policy focus from the early confrontational approach to giving fresh attention to tackling the challenges associated with relying on MNEs as a vehicle for achieving developmental objectives through global integration. Although the general role of MNEs in development is well recognized, there

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is no consensus on appropriate national policies toward MNEs; the extent and form of government regulations relating to both MNE entry and their domestic operations, and the underlying raison d’être, differ enormously among countries. Improved development outcomes from relying on MNEs as development partners are clearly tied to our ability to cast a fresh look at the implications of the increasing role of MNEs in the global economy for domestic economic governance in host countries. Over the past two decades, there has been a boom in academic research analysing the economics of MNEs, but very few attempts have been made to address key issues in this policy debate. This book, which examines selected issues relating to the MNE–development interface with emphasis on the experiences of developing countries in Asia, is an attempt to fill this knowledge gap. Developing Asia provides an excellent laboratory for studying the selected (and related) issues, given the variety of experiences relating to the nature and extent of MNE involvement and the related policy regimes, both across countries in general and over time within most countries. In each chapter, the Asian experience is examined in the context of the existing literature on the patterns and developmental implications of MNE involvement in the global economy. Following this introductory chapter, Chapter 2 sets the context for the ensuing chapters. It begins with a succinct account of the evolution over the post-war years and the current state of national policies toward MNE participation in developing Asian countries. This is followed by an overview of the comparative performance of the developing Asian countries as hosts to MNEs in a global context, using data on gross FDI inflows as the prime indicator of MNE participation. The chapter also examines the emerging patterns of source-country and industry composition of FDI flows, and makes inferences about prospects for attracting FDI in the context of the contemporary debate on the possible crowding-out effect on other countries in the region of China’s emergence as an attractive location for FDI. Chapter 3 takes a fresh look at the role of MNEs in the expansion of manufacturing exports. The analysis here is motivated by the concern that, given major changes in the investment climate in developing countries and in patterns of international production over the past two decades, evidence from the early experience of the newly industrialized countries (NIEs) in East Asia may send the wrong signals to policy makers in latecomer exporting countries. First a typology of the involvement of MNEs in manufacturing for export is developed, based on the premise that MNEs are not a homogeneous but a finely differentiated instrument of global integration. The typology is then applied to empirical evidence from NIEs and latecomer exporting countries in developing Asia. The evidence suggests that

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the share of MNEs in manufactured exports from all countries has recorded a significant increase from about the mid-1970s and that, contrary to the historically specific experience of Korea and Taiwan (and also Japan), the entry of MNEs is virtually essential for the export success of latecomers. The findings reported in this chapter make a strong case for concomitant liberalization of trade and investment policy regimes in determining gains from export-led industrialization. ‘International product fragmentation’ – the splitting of the production process into discrete activities which are then allocated across countries – has been a key factor in the rapid expansion of MNE involvement in the global economy over the past three decades. Chapter 4 provides fresh estimates of the extent and growing importance of this phenomenon in world manufacturing trade and examines the implications of this phenomenon for global and regional trade patterns, with special emphasis on countries in East Asia, using a new data set culled from the UN trade database. It is found that, while fragmentation-based trade (trade in parts and components) has generally grown faster than total world trade in manufacturing, the degree of dependence of East Asia on this new form of international specialization is proportionately larger than that of North America and Europe. The upshot is that international product fragmentation has made the East Asian growth dynamism increasingly reliant on extra-regional trade, strengthening the case for a global, rather than a regional, approach to trade and investment policymaking. Chapter 5 deals with the current debate on the relative stability of FDI compared with the other forms of capital flows and the role of MNE affiliates in economic adjustment in the context of international financial crises. More specifically, is foreign direct investment more resilient at the onset of an economic crisis and during the subsequent economic collapse in a given host country than other forms of foreign capital inflows? Are affiliates of multinational enterprises in a crisis-hit country better equipped to withstand a crisis and to aid the recovery process by readjusting their investment, production and sales strategies than local firms are? In this chapter, these and related issues are analysed, drawing upon the experiences of East Asian countries in the recent (1997–98) financial crisis. The findings suggest that FDI was indeed a relatively stable source of foreign capital in the crisis context and that MNE affiliates were instrumental in ameliorating the severity of economic collapse and facilitating the recovery process. In Chapter 6, the nexus of real exchange rate and capital inflows is examined, with emphasis on the difference between FDI and other forms of capital flows, through a comparative analysis of the experiences of emerging market economies in Asia and Latin America during the period

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1985–2000. It is found that the degree of appreciation of the real exchange rate associated with capital inflow is uniformly much smaller in Asian countries than in their counterparts in Latin America, despite the fact that the former experienced far greater foreign capital inflows relative to the size of the economy. The econometric evidence suggests that both the composition of capital flows and the differences in the degree of response of the real exchange rate to capital flows matter in explaining these contrasting experiences. While real exchange rate appreciation is a phenomenon predominantly associated with other (non-FDI) forms of capital inflows, a given level of other capital flows brings about a far greater degree of appreciation of the real exchange rate in Latin America, where the importance of these flows in total capital inflow is also far greater. The effect of trade policy regimes on national economic gains from international production in foreign direct investment receiving countries is an issue of obvious policy relevance and analytical interest, but one on which there has been a dearth of empirical research. Chapter 7 aims to fill this gap by examining the determinants of productivity of international production using a cross section of data on overseas operations of manufacturing affiliates of US MNEs operating in 44 countries. The findings support the proposition that, other things being equal, productivity gains from international production tend to be greater under a more open trade policy regime than under a restrictive regime. There is also evidence of a significant negative effect of a stringent domestic tax regime on efficiency gains from international production. Chapter 8 examines patterns and determinants of overseas R&D expenditure of US-based manufacturing MNEs using a new panel data set over the period 1990–2001. It is found that inter-country differences in the R&D intensity of operation of US MNE affiliates are fundamentally determined by the domestic market size, overall R&D capability and cost of hiring R&D personnel. There is modest statistical support for the hypothesis that geographical distance has a positive impact on the R&D intensity of MNE affiliates. The impact of domestic market orientation of affiliates on R&D propensity varies among countries according to their stage of global economic integration. Intellectual property protection seems to matter largely for mature economies with complementary endowments. There is no evidence to suggest that financial incentives have a significant impact on intercountry differences in R&D intensity when controlled for other relevant variables. Nor is there a statistically significant relationship between the size of the capital stock of MNEs and the R&D intensity of their operation across countries. Overall, our findings serve as a caution against hostcountry governments paying too much attention to turning MNEs’ affiliates into technology creators as part of their foreign direct investment policy.

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Chapter 9 deals with an important, yet hitherto sparsely studied, issue central to the fledgling literature on multinational enterprises based in developing countries, namely whether they bring in more appropriate technology to host developing countries compared with their developed-country counterparts. Using hitherto unexploited firm-level data relating to Sri Lankan manufacturing, the chapter examines the differences in capital intensity of production between affiliates of developing-country and developed-country MNEs and indigenous private firms by applying a methodology which avoids some of the major drawbacks of the few previous studies. In a simple comparison of average capital per worker, affiliates of developed-country MNEs generally do exhibit a higher degree of capital intensity than those of their developing-country counterparts as well as indigenous private firms. However, when controlled for firm attributes other than parentage that can affect capital intensity, it is found that the link between parentage and capital intensity is industry specific. There are marked differences in capital intensity between the two types of foreign affiliates in the textile and wearing apparel industries. However, no such differences could be observed in other industries. All in all, the results support the view that developingcountry MNEs adopt more appropriate technology only in those industries where the range of technological possibilities is wide enough to enable significantly different techniques of production to be utilized. Finally, Chapter 10 examines the role of MNEs and foreign direct investment in the process of economic transition from ‘the plan to market’ through a case study of the Vietnamese experience. It surveys the evolution of FDI policy in Vietnam in the context of overall policy reforms and the current state of the investment climate, and examines the experience of attracting FDI from a comparative regional and global perspective. This is followed by an analysis of the impact of the operations of MNE affiliates on economic performance. The Vietnamese experience provides ample support for the view that both the rate of FDI involvement in the economy and the national developmental gains from FDI depend crucially on the level of economic transition as reflected in the extent of privatization/restructuring of state-owned enterprises, market-based decision making and the creation of a legal and institutional framework for foreign and private domestic investment.

NOTES 1. In line with usual practice in this area of study, the multinational enterprise (MNE) is defined here as an enterprise that owns and controls business ventures in more than two countries (including its home country).

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2. FDI is ‘the category of international investment that reflects the objective of a resident entity in one economy to obtain lasting interest in an enterprise resident in another country’ (IMF 1993, p. 86, emphasis added). Here the resident entity is the direct investor (the MNE) and the enterprise is the direct investment enterprise (the foreign affiliate). The lasting interest implies the existence of a long-term relationship between the MNE and the affiliate and a significant degree of influence by the former on the management of the latter. It is this lasting interest that distinguishes direct investment from portfolio investment and other forms of international capital flows such as foreign aid and commercial bank lending. 3. Data reported in this paragraph are from the UNCTAD World Investment Report database (www.unctad.org). 4. Unlike ODA, FDI is concentrated in a handful of developing countries. However, in recent years FDI inflows have surpassed ODA in the bulk of developing countries, including the least developed countries (LDCs) (UNCTAD 2005). 5. Limitations of FDI as an indicator of the activity of MNE affiliates in host (investment receiving) countries are discussed in Chapter 2. 6. Lipsey (2004) provides an extensive survey of the related literature. 7. For an extensive survey of this literature, see Helleiner (1989).

2. Foreign direct investment in developing Asia: trends, patterns and prospects The purpose of this chapter is to provide the context for the ensuing chapters. It begins with an overview of the evolution and the current state of national policies toward MNE participation in Asian developing countries.1 This is followed by a survey of the global spread of multinational enterprises (MNEs) as measured by foreign direct investment (FDI), with emphasis on the relative position of developing Asian countries as hosts to MNEs, focusing in turn on trends in total FDI inflows against the backdrop of global trends, and emerging patterns of source-country and industry composition of these flows. FDI is the commonly used and readily available measure of global operations of MNEs. In addition to measurement problems involved in balance of payments records of FDI (to be discussed below), this measure has many defects as an indicator of the activity of MNE affiliates in their host countries (UNCTAD 2001, Lipsey 2004). For instance, the parent company may take a minority ownership position in a foreign subsidiary because of ownership restrictions imposed by the host country or for other strategic reasons and yet control the activities of the latter, given its command over production technology, management practices and marketing channels. The actual activity of a given affiliate may not necessarily be in the same industry as that to which FDI inflows are ‘officially’ related, or even in the same host country. Moreover, given scale economies of operation and differences in capital intensity across various industries and sectors of production, a given level of FDI could well imply vastly differing scales of MNE involvement among countries. Given these limitations, direct performance indicators such as sales, output or employment of MNE affiliates are needed to get a better understanding of their operations in host countries. Unfortunately such indicators are not available for most countries, including a large number of developed countries.

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POLICY CONTEXT The term ‘foreign investment regime’ (or policies toward MNE participation in the national economy) is used here in the broader sense to cover rules governing foreign investment and specific incentives offered to investors. Foreign investment regimes of Asian countries have gone through several changes in the post-war period. As an integral part of a palpable shift away from import-substitution towards export-oriented development strategy, the policy regimes have become more liberal over time, not only in the sense of reduced bureaucratic impediments to the entry of foreign firms but also in that the sectors open to foreign investment have been expanded. From about the late 1980s, if there is a concern about FDI it is more likely to have been about insufficiency, in contrast to earlier concerns about an excessive foreign presence. There are, however, significant differences among Asian countries in terms of the nature of their commitment to FDI promotion and timing of related policy shifts during the precrisis era. Hong Kong Hong Kong is in a class of its own in terms of its long-standing laissez-fare approach to foreign direct investment. Historically, Hong Kong evolved economically as an entrepot for South China and politically as a colony of Great Britain. Consequently, it is unique for its well-established tradition of free trade and investment (Lin and Mok 1985). This policy stance has so far remained intact in spite of Hong Kong becoming a Special Administrative Region of China in 1991. Business licensing does not exist except for public utilities and banking. The Hong Kong firms and foreignowned firms operate side by side without discrimination or control. There are across-the-board low income taxes for all investors. There are no special tax incentives for foreign investors. Korea and Taiwan Korea and Taiwan (like Japan) have historically adopted a more cautious approach to FDI as a means of developing indigenous technological capability. During the import-substitution phase of industrialization during the post-war period up to about the late 1960s, foreign investment was welcomed into the light manufacturing export sector, but the overall policy stance towards foreign investment continued to be passive and highly selective. The first attempt by the Korean government to provide a legal basis for the attraction of foreign capital was made in January 1960, through the

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enactment of the Foreign Capital Inducement Promotion Act. This stipulated equality of treatment and even some tax incentives. In the first Five Year Plan, begun in 1962, the government realized the importance of foreign capital, and thus adopted more concrete measures to encourage FDI inflows, but only if they would not hurt domestically owned firms. FDI approval guidelines and procedures were further streamlined in 1973 with a view to providing local firms with breathing space at the formative stage of entrepreneurial development. The most important change was that increased emphasis was placed on encouraging the setting up of joint ventures rather than wholly foreign-owned firms. Industry-specific guidelines relating to project eligibility, foreign equity share and investment scale were also adopted and specific industries not open to foreign investors were clearly demarcated. These heavy-handed criteria remained the backbone of Korean FDI policy until the late 1970s (Koo 1985). There was a notable move toward FDI liberalization from the early 1980s, following the failure of the Heavy and Chemical Industry Promotion Plan of the 1970s. Investment approval guidelines were considerably liberalized in September 1980, allowing FDI in many new areas, permitting firms to be majority- or wholly-owned by foreign investors in many additional cases and reducing the minimum amount of investment. In December 1989, various performance requirements imposed on foreigninvested firms, such as requirements relating to local content, export and technology transfer, were abolished. In December 1996, when Korea joined the OECD, a new Act on Foreign Direct Investment and Foreign Capital Inducement replaced the Foreign Capital Inducement Act. The new act aimed to provide the setting for a shift in FDI policy away from the historic ‘promotion’ role towards a more flexible ‘facilitating’ role. These initiatives notwithstanding, Korea’s overall stance towards FDI continued to be quite restrictive by the Southeast Asian standards (Kim and Hwang 2000). Following the onset of the financial crisis in 1997, the Korean government departed radically from its traditional closed economy approach to FDI. As part of its crisis management policy, the Korean government embarked on a more active promotion of FDI. In November 1998, as part of the reform program agreed with the IMF, the government enacted the Foreign Investment Promotion Act, with a view to creating an investororiented policy environment. The act provided for streamlining foreign investment approval procedures, expanding investment incentives, and the establishment of an institutional framework for investor relations. There was also full-fledged liberalization in the areas of cross-border mergers and acquisitions and foreign land ownership. In June 1998, the government bound its commitment to liberalization of financial services agreed with the OECD as part of its commitment to the World Trade Organization (WTO),

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thus contributing to strengthening investor confidence in the new FDI liberalization drive. Under the new Foreign Investment Promotion Act, foreign investment restrictions were eased across a wide range of sectors, including banks, other financial institutions and activities, real estate and land, and stateowned utilities targeted for privatization. The most significant initiatives included permitting foreigners to engage in deep-sea foreign transport; increasing the foreign ownership ceiling on publishing newspapers to 30 per cent and periodicals to 50 per cent; increasing the permitted equity ownership by foreigners of Korean telephone service provision from 33 to 49 per cent; allowing foreign financial institutions to participate in mergers and acquisition of domestic financial institutions on equal principles; permitting foreign financial institutions to establish subsidiaries; allowing foreign participation in merchant banks up to 100 per cent; and abolishing restrictions on foreign ownership of land and real estate properties on the basis of national treatment. In Taiwan, during the first decade of post-colonial development (1951 to 1960), the government discouraged FDI in order to promote a new indigenous industrial entrepreneurial class. In 1952 the government promulgated legislations to encourage investment in productive enterprises by overseas Chinese and Chinese residents in Hong Kong and Macao. These investors were permitted to invest in any industry – real estate and services industries in particular. From about the early 1960s, the policy regime became more receptive to non-Chinese foreign investors. But, as in Korea, the government played a very active role in directing investment into selected sectors/ industries in line with national developmental priorities (Ranis and Schive 1985). In order to engage foreign firms in the export promotion drive in a more liberal policy setting, the first export processing zone (EPZ), in the vicinity of Kaohsiung, Taiwan’s largest harbour, was established in 1966. Two more were added five years later (Schive 1990). However, promoting nationally owned firms, private and public, in both industry and services continued to be the general thrust of the industrial policy of Taiwan until the mid-1980s. Competition from foreign investors was structured in such a way as to strengthen national firms through technology transfer and ‘spillovers’ (Amsden and Chu 2003). The Taiwanese FDI policy has become increasingly liberal as part of market liberalization reforms beginning in 1986. Among other measures, liberalization included relaxing and finally removing foreign equity limits on joint ventures, opening markets to new foreign entrants in virtually all manufacturing industries. However, until recently, the government continued to provide local firms with a head start over foreign firms in key services such as banking and telecommunications (Amsden and Chu 2003).

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Multinational enterprises in Asian development

Restrictions on foreign investment in services were later selectively lifted as part of the reform process leading to Taiwan becoming a WTO member in 2002. ASEAN Countries Among the member countries of the Association of South East Asian Nations (ASEAN), Singapore has throughout maintained a solid reputation for providing the most favourable FDI regime in the region (and one of the most favourable in the world) (Chia 1985, Hughes and You 1969). The entry of FDI to Singapore is largely unrestricted and there is no need for formal approval of investment projects. There is no specific foreign investment law. Nor are there restrictions on repatriation of funds or regulations concerning foreign ownership. Remaining restrictions on FDI in telecommunications and legal services were lifted in 2000 as part of liberalization commitments under the World Trade Organization. The main form of encouragement for foreign and domestic investors alike remains the ‘pioneer status’ introduced by the Pioneer Industries Ordinance Act of 1959. Pioneer status carries tax holidays of five to ten years, which may be extended depending upon possible additional income generation due to the expansion of activities. Special benefits are available for firms which have a high share in manufacturing exports and/or bring in new technologies. The liberal FDI regime in Singapore is an integral part of an overall economic policy regime which has maintained an impressive track record in meeting other prerequisites of a good investment environment (such as high-quality infrastructure and financial services, market-friendly labour market practices, and transparent/expedient legal procedures) (Huff 1994). In the 1960s and 1970s, policy towards FDI in the other four original ASEAN member countries (Indonesia, Malaysia, Thailand and the Philippines) remained ambivalent, alternating between a national distrust of foreign firms and the hope that new foreign investment could provide the technology and capital for rapid industrialization (Lindblad 1998, Chapter 5). FDI policy was thus characterized by a mix of incentives and restrictions, with the balance between the two varying among countries and over time depending on the strength of prevailing anti-FDI sentiment (which was particularly strong in the Philippines and Indonesia). The investment regime of Malaysia, which remained relatively liberal by regional standards in the 1960s, became much more restrictive following the introduction of bumiputra ownership and employment requirements under the New Economic Policy (NEP) (Athukorala and Menon 1996). The other countries gradually began to introduce pro-active FDI policies,

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including offering various fiscal incentives. But foreign participation remained generally limited to minority ownership. Only pioneer status would qualify for full foreign ownership during the initial stage of operations. Unlike in India, however, there were no restrictions on procurement of foreign technology and the repatriation of profit and capital. From the late 1980s, as an integral part of a palpable shift away from import-substitution towards export-oriented development strategy, FDI policy regimes in these countries have become increasingly liberal. By the mid-1990s, full foreign ownership of firms producing for export was a common feature and ownership restrictions had become increasingly liberal even for firms involved in domestic-market-oriented production. The requirement for registering with the Board of Investment had been abolished in Thailand and it was applied only to firms with 40 per cent of foreign equity in the Philippines. In other countries formal approval remained in force, but the approval procedures had become much simpler and less time consuming. All countries had moved to the so-called ‘negative list’ approach to investment approval, which involves governments explicitly listing those activities closed to FDI, with the implication that any activity not so listed is open. However, the governments continued to restrict foreign participation in such services as media, real estate, energy and utilities. These significant moves towards providing greater opportunities for global integration through FDI occurred in a general economic setting which became increasingly conducive to private sector participation in the growth and development process. The investment environment had become increasingly favourable for a number of reasons, including political stability and policy continuity, an impressive record in maintaining macroeconomic stability, and a proven track record in meeting infrastructure requirements for rapid growth. Beneath these general trends, there were of course considerable differences among countries. By the mid-1990s, Malaysia was generally considered to have the most favourable foreign investment climate in the region (after Singapore), followed by Thailand, Indonesia and the Philippines in that order (Lindblad 1998, Hill 2004). Following the onset of the financial crisis in 1997, as part of the crisis management policy, the governments of the four crisis-affected ASEAN countries (Indonesia, Malaysia, the Philippines and Thailand) embarked on a more active promotion of FDI. In Thailand, nearly all services and manufacturing sectors were opened to FDI and restrictions on FDI in the real estate and financial sectors were considerably relaxed as part of the policies that Thailand agreed to implement in the context of its request for financial support from the IMF (Kohpaiboon 2006). In Indonesia, as part of the reform package agreed upon with the IMF, the government committed itself to promote foreign direct and equity

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investment and to implement a number of measures to increase these flows. In late 1999, the Indonesian Government proposed to reorganize the Investment Board (BKPM) into a new institution under the Coordinating Minister for Economic Affairs, which will focus on investment promotion rather than regulation activities. Implementation of these proposals has been hampered by political turmoil. Measures implemented include significantly narrowing the list of sectors that are closed to foreign investment (in July 1998) and lifting restrictions on foreign investment in wholesale trade. Malaysia has continued to give priority to promoting FDI, despite its radical policy shift in September 1998 (Athukorala 2002a). The newly introduced capital controls were confined to short-term capital flows and aimed at making it harder for short-term portfolio investors to sell their shares and keep the proceeds, and for offshore hedge funds to drive down the currency. With the exception of limits on foreign exchange for foreign travel by Malaysian citizens, there was no retreat from the country’s long-standing commitment to an open trade and investment policy. No new direct controls were imposed on import and export trade. Profit remittances and repatriation of capital by foreign investors continued to be free of control. Immediately following the imposition of capital controls, the Central Bank of Malaysia (Bank Negara Malaysia, BNM) did experiment with new regulatory procedures in this area. But these were swiftly removed in response to protest by these firms. Moreover, some new measures were introduced to further encourage FDI participation in the economy. These included allowing 100 per cent foreign ownership of new investment made before 31 December 2000 in domestic manufacturing regardless of the degree of export orientation; increasing the foreign ownership share in telecommunication projects from 30 to 69 per cent (on condition that the ownership share is brought down to 49 per cent after five years) and in stock-broking companies and the insurance sector from a previous uniform level of 30 per cent to 49 and 51 per cent respectively; and relaxing restrictions on foreign investment in landed property to allow foreigners to purchase all types of properties above RM 250 000 in new projects or projects which are less than 50 per cent completed. In the Philippines, the crisis itself has not resulted in a significant shift in the country’s policy towards FDI. However, the emphasis on the promotion of export-oriented foreign investment, which started in earnest in the late 1980s, seems to have received further impetus following the crisis (Hill 2003). Among the four new ASEAN member countries, in Vietnam significant opening of the economy to FDI was part of the ‘renovation’ (doi moi) reforms initiated in 1986 (Riedel and Comer 1997, Freeman 2004). With a slow and hesitant start in the late 1980s, significant reforms were under-

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taken in the first half of the 1990s. The reform process lost momentum during 1996–98 partly owing to the East Asian crisis of 1997–98, but partly (perhaps even more so) owing to domestic policy ambivalence and complacency resulting from the success of the initial reforms. There has however been a renewed emphasis on completing the unfinished reform agenda over the past three years.2 In Cambodia the Kampuchea People’s Revolutionary Party (KPRP) government embarked on a market-oriented reform process in 1985. As part of these reforms, the government promulgated a liberal foreign investment code in July 1989 and a National Investment Council was set up in 1991 with the task of reviewing all foreign investment applications. The outcome of these reforms was somewhat lacklustre, however, and perhaps unsurprising given the continuing warfare between KPRP forces and the Khmer Rouge. As an outcome of the UN-led peace process, elections were held in July 1993 and a multi-party democratic government was established in September 1993. The new government set up the Cambodian Investment Board (CIB) under the Council for Development of Cambodia (CDC) to be the ‘one-stop’ service organization responsible for approving foreign investment applications. The new Laws and Regulations on Investment in the Kingdom of Cambodia, passed by the National Assembly on 4 August 1994, set out rules and regulations governing FDI and offered an incentive package which was very generous compared with those in other countries in the region. The foreign investment regime in Cambodia underwent an overhaul in 2003. The revised Law on Investment came into force on 27 September 2005, and represented a major attempt to equalize incentives for foreign and local investors, to achieve greater transparency in incentives provided, and to minimize distortions and delays arising from policy maker discretion. As part of the new reforms, a fast-track procedure has been introduced with the aim of approving investment applications within a 14-day period under the ‘one-stop’ service at the CIB. Seven working groups, which involve both private and public sector participation, have been set up in key sectors to work in collaboration with the CIB to facilitate speedy investment approval, monitoring and promotion. An investor forum, headed by the prime minister, is to be held twice a year as part of the new investment regime. In December 2005, a Sub-Decree was passed to provide the legal framework for setting up special economic zones (SEZs) (which may include general industrial zones and/or export processing zones (EPZs)). The transition to a market-oriented economy in Lao PDR began in 1985 with the announcement of the New Economic Mechanism, a major program of economic reforms. As part of the reform program a Foreign Investment Code was passed in July 1988 and the Foreign Investment

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Management Committee (FIMC) was set up under the direct purview of the prime minister to act as the apex agency that approves, monitors and promotes FDI. At the initial stage, the prime objective of FDI policy in Lao PDR was to engage foreign investor participation in restructuring of state-owned enterprises (SOEs). The Foreign Investment Code was supplanted in July 1994 by the Law on Promotion and Management of Foreign Investment, which was in turn substantially revised in October 2004. Foreign investment is now permitted in joint ventures or fully foreign-owned projects in all business sectors, except in mining and energy projects in which the government contributes to share capital or retains the right to buy a preagreed share of equity. The structure of tax incentives for foreign investors has been designed to take into account the country’s peculiar geography (mountainous terrain) and uneven quality of infrastructure in different parts of the country. For large projects in the mining and energy sectors (which by their very nature tend to be located in remote areas), specific taxation arrangements are negotiated on a case-by-case basis. Finally, in Myanmar the potential for attracting FDI investment has remained subdued because of continuing political problems (Athukorala et al. 2000). China Perhaps the most significant element in economic reforms in China since 1979 has been the opening up of the economy to foreign direct investment. The 1979 Joint Venture Law permitted FDI for the first time since 1949. This landmark legislation codified the right of foreign firms to invest in China and to cooperate with Chinese enterprises in various ways. It defined the nature of joint ventures that would be allowed to invest in China and set the stage for the process of establishing an institutional and administrative framework for monitoring FDI. Several laws aimed at specific issues relating to foreign investment were introduced between 1979 and 1986 (Lardy 2002, Huang 2003, Pomfret 1991). The centrepiece of China’s formal FDI promotion policy has been the special economic zones (SEZs). Chinese authorities chose SEZs as a compromise solution to the problem of introducing foreign investors and their capital participation into China while limiting the political repercussions of opening up. The original inspiration for the SEZs came from the EPZs of East Asia, but they have special Chinese features. The SEZs are much larger than EPZs. Unlike EPZs elsewhere in the region which are typically run by management companies or boards which come under the purview of the central government, SEZs are government units in their own right. In terms of objectives, the SEZs were not just to be vehicles for expanding exports. They were also assigned a central role in the reform process as ‘windows

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and bridges’ to the outside world, in both directions, and also as ‘economic laboratories’ in which economic policy experiments could be tried out in a geographically restricted area. A striking feature of the FDI regime as it evolved in the 1980s was its dualistic nature. The export-oriented (EO) or export-promotion (EP) regime was generally restricted to foreign firms. During the ensuing years, some of the special provisions to attract FDI which until then had been available only in the SEZs were made much more widely available. At the same time sectors such as retailing, power generation and port development were gradually opened up for foreign investors. Since 1992 significant domestic market access has been given to foreign investors, particularly those who could offer advanced technology. Foreign capital participation in property development (including residential housing) was liberalized in the early 1980s. South Asia During the first three decades of the post-war era, South Asia remained perhaps the most inward-oriented group of countries in the world outside the communist bloc. These countries maintained strict controls on foreign investment in import-substituting manufacturing and other sectors while giving special incentives for export-oriented investment. Technology licensing and joint ownership with local firms were the most preferred forms of foreign investment. Naturally, the latter policies were not to bring about any tangible result, given the anti-export bias in the overall incentive structure. Sri Lanka took the lead in breaking away from the protectionist past, by embarking on a decisive process of economic opening in 1977. Following hesitant and sporadic attempts to dismantle trade barriers in the 1970s, other countries embarked on significant liberalization reforms from the late 1980s. While there are vast inter-country differences in terms of the degree of liberalization achieved during the ensuing years, by the mid-1990s all five countries seemed to have moved into a seemingly irreversible process of economic liberalization and greater receptivity to foreign investment. During the first four decades following independence in 1947, India’s policy with respect to FDI (and other types of foreign capital) remained highly restrictive, as part of a stringent import-substitution industrialization strategy.3 The government did not rule out new foreign investment, but wanted it on its own terms. With a view to minimizing foreign exchange outlay relating to technology acquisition, as far as possible technologies were to be acquired through licensing rather than through FDI. All foreign investment applications were considered on a case-by-case basis and that too within a normal ceiling of 40 per cent of total equity investment. Major

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commercial banks and foreign oil companies were nationalized in the 1970s. The Foreign Exchange Regulation Act of 1973 required firms to dilute their foreign equity holdings to 40 per cent if they wanted to be treated as Indian companies.4 There was severe curtailment of intellectual property rights. For instance, product patents were abolished in industries such as pharmaceuticals and chemicals and the duration of process patents was drastically reduced. The regulatory mechanism governing the entry of MNEs was characterized by an explicit preference for technical collaboration agreements as opposed to FDI; a policy stance dictated by the desire to achieve the (conflicting) twin objectives of minimizing foreign control on business operations and gaining access to foreign technology. In the mid-1960s, India set up two free trade zones (FTZs) to promote export-oriented foreign investment alongside the highly restrictive trade and investment policy regime. But these FTZs never took off for several reasons, such as their relatively limited scale, the government’s general ambivalence about attracting FDI, the unclear and changing packages attached to the zones, and the power of the central government in the regulation of the zones (Bajpai and Sachs 2000, Kumar 1989). In the 1980s, there was some softening of the FDI approval procedure for export-oriented activities and some high-tech industries, but the overall policy stance remained one of the most stringent in the developing world. Foreign investment policy was substantially liberalized at an early stage of the 1991 economic reforms and the process was extended further in the subsequent years (Balasubramanyam and Mhambare 2003). Foreign ownership up to 51 per cent is now permitted in a wide range of industries. Foreign ownership up to 100 per cent is permitted on a case-by-case basis in some designated (priority) areas (pharmaceuticals, airports, suburban development, hotels and tourism, courier services and mass rapid transport systems) and up to 74 per cent in the telecommunication sector. Technology policy has been reformed to give greater recognition to intellectual property rights. Procedures for obtaining permission were also greatly simplified, requiring only registering with the Reserve Bank of India (RBI). Firms are now free to negotiate the terms of technology transfer on the basis of their own commercial judgment and without the need for government approval for hiring of foreign technicians and foreign testing of indigenously developed technology. Despite recent reforms, India’s foreign investment regime still reflects the tension between the traditional aversion to foreign investment and the current recognition of its importance to economic development.5 For example, FDI is still not permitted in pure retailing; global retailers can only participate in India’s retail sector through wholesale trade or by operating retail outlets through local franchises. In apparel and other light

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consumer-good producing industries, which are important in export expansion and job creation at the current stage of economic development of the country, FDI is limited to 24 per cent of total equity. Restrictions on foreign ownership of land limit the entry of foreign builders and developers into the construction sector (see World Bank 2003b, pp. 55–66 for details). Projects with 51 per cent or more foreign ownership still require a long procedure of government approval. There are also many unresolved problems relating to the overall investment climate (World Bank 2003b). Tariff protection in India is still substantially higher than in most other developing countries, and this continues to block India’s attractiveness as an export platform for labourintensive manufacturing products. While the ‘Licence Raj’ (the infamous industrial licensing policy) has been largely eliminated at the centre, it still survives at the state level, along with a pervasive ‘Inspector Raj’. Private investors require a large number of permissions (for electricity and water supply connections, water supply clearance and so on) from state governments to start business and they also have to interact with the state bureaucracy in the course of day-to-day business.6 Stringent labour laws and high corporate tax rates,7 restrictive labour market practices and a weak bankruptcy framework are other prominent issues. Pakistan has a checkered history of trade liberalization and FDI promotion. Following some trade liberalization attempts in the 1960s, Pakistan qualified for Article VIII status at the IMF in 1970. Even by the mid-1980s there was still a long way to go in lifting QRs and reducing tariffs. From the mid-1980s, controls on foreign investment in manufacturing have diminished sharply, those for the service sector less so. In spite of various bureaucratic controls, the government attitude throughout the 1950s and 1960s was favourable to private investment (Bose 1983, Guisinger and Scully 1991). The FDI regime was more liberal, although there was greater emphasis on joint ventures with minority foreign ownership and technology licensing than on FDI in fully foreignowned ventures. However, supremacy of the state and socialist ideology under a socialist government dominated policy in the 1970s. As a result, a large-scale program of nationalization of key industrial units and widespread control of domestic and foreign trade were instituted. The dismal economic outcome of the interventionist policies eventually paved the way for market-oriented reform. Reforms started slowly in the early 1980s as part of a widespread reform package in conformity with the World Bank conditionality. Removal of restrictions on foreign investment was a major element of the reform program. Full foreign ownership of firms, with full freedom for remittance of profit and investment proceeds, is now allowed in almost all sectors of the economy.

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Following independence in 1971, the Bangladesh government adopted a state-led import-substitution development strategy, which was far more interventionist than that of the united Pakistan. The new government nationalized a large number of industrial enterprises owned by Pakistani entrepreneurs as well as all industrial enterprises with fixed assests exceeding a certain threshold level. The scope of the private sector was limited to small and cottage industry, and foreign investment was allowed only in collaboration with the public sector with minority equity participation. However, existing foreign investments (excluding those belonging to Pakistan) were spared from the sweeping nationalization drive. The socialist-oriented industrial policy of 1973 assigned a very minor role for the private sector, with some investment ceiling on new investment. The next two years were a period of extreme political and economic turmoil. With the change of government in 1975, the strategy of publicsector-led industrialization was abandoned. The new policy reforms, introduced with a view to giving more room to the private sector, included further raising of the investment ceiling and its elimination in 1978, reducing the number of industries reserved for the public sector, streamlining investment approval procedures, and amendment of the constitution to allow denationalization. Further significant changes were introduced in 1980 with the enactment of two pieces of legislation. The Foreign Investment (Promotion and Protection) Act of 1980 provided for the protection and equitable treatment of foreign investment, guarantees against expropriation or nationalization without compensation, and repatriation of invested capital and profits. The Bangladesh Export Processing Zone Authority Act, also passed in 1980, provided for the setting up of three export processing zones during the ensuing decade. The subsequent reforms in the early 1990s included allowing 100 per cent foreign ownership in all foreign investment projects and extending EPZ privileges to all export-oriented projects regardless of their location (Rahman and Bakht 1997, Ali 1999). In Sri Lanka, foreign investment policy remained extremely liberal until the mid-1960s, permitting many MNEs to set up affiliates within Sri Lanka to undertake the domestic production of items previously supplied from their overseas production centres. However, as the import-substitution industrialization strategy was reaching a crisis point by the mid-1960s, the view (which was widely held among development economists at the time) that ‘import-substituting MNEs worsen countries’ balance of payments’ began to dominate Sri Lanka’s policy towards FDI. This view resulted in a dualistic foreign investment policy characterized by stringent restrictions on import-substitution projects and preferential treatment for export-oriented ventures. From about the late 1960s, there was some policy emphasis on the

Foreign direct investment in developing Asia

25

promotion of export-oriented FDI through selective incentives. A White Paper on foreign investment issued in 1966 introduced various tax concessions for export-oriented foreign ventures and relaxed foreign exchange restrictions on the remittance of dividends, interest and profit originating in such ventures. The government’s commitment to the promotion of exportoriented FDI was reaffirmed and further production and tax incentives were introduced by the Five-Year Plan, 1972–77 (Government of Sri Lanka 1972). However, this policy shift in favour of EOFDI occurred in an overall policy and political context which was highly unfavourable to private sector activities in general and to export production in particular. Reflecting the cumulative impact of stringent trade controls, high export taxes and the overvalued exchange rate, the overall incentive structure of the economy was characterized by a significant ‘anti-export bias’ throughout this period (Athukorala and Jayasuriya 1994). As a reaction to the dismal economic outcome of its inward-looking policy, Sri Lanka embarked on an extensive economic liberalization process in 1977, becoming the first country in the South Asian region to do so. Liberalization of the foreign direct investment regime, with a major focus on attracting export-oriented FDI, was a key element of the reform program.8 During the post-war period until the mid-1980s, Nepal continued to pursue import-substitution development strategy in the context of a highly protectionist trade and investment regime. During this period, FDI was allowed only in some selected industries. There were also stringent limits on the share of foreign ownership. There has been a clear policy shift in favour of market-oriented outward-looking development strategy, starting with the Structural Adjustment Policy (SAP) package of 1985. As part of these reforms, Nepal has made substantial changes in its FDI policies as an effective means of promoting private-sector-led growth. The Industrial Policy and Industrial Enterprise Act promulgated in 1987 provided a legal framework to facilitate FDI in medium- and large-scale ventures in all industries with the exception of environment and defence related activities. A new Foreign Investment Promotion Division was created at the Ministry of Industry to act as the central body for the approval and monitoring of FDI projects. FDI was not allowed in small-scale industries, while foreign equity ownership of up to 50 per cent was permitted in medium-sized industries. In large firms with at least 90 per cent of export sales, 100 per cent foreign ownership was allowed. A five-year tax holiday is applicable to export-oriented firms. Subsequent changes to FDI law include expanding the scope of FDI in all industries except defence, cigarettes and alcohol; streamlining the approval procedure; entering into investment protection and agreements to avoid double taxation with major investing countries; reduction of corporate tax rate (in 1997) on domestic-market-oriented FDI projects and FDI

26

Multinational enterprises in Asian development

projects in services to 20 per cent and giving export-oriented firms the option of corporate tax at the rate of 0.5 per cent of export value (FOB) or 8 per cent of profit; and reduction (in 1996) of the minimum fixed asset limit on new firms to Rs 500 million. A new 5 per cent tax on profit remittances by foreign firms was introduced in the 1999/2000 Budget because of balance of payments exigencies (Athukorala and Sharma 2005).

TRENDS This section is based on data compiled from UNCTAD’s World Investment Report, which is now the standard data source in this area. Before proceeding to analyse the data, a cautionary note about the data quality is in order. According to the standard definition, FDI consists of three components. These are equity capital: shares owned by the foreign direct investor (MNE) in its affiliates firms; retained earnings: the MNE’s share (in proportion to direct equity participation) of earnings not distributed as dividends by affiliates or earnings not remitted to the parent company (such retained profits are reinvested by affiliates); and intra-company loans or intra-company debt transactions, referring to short- or long-term borrowing and lending of funds between the parent company and affiliated enterprises. Not all countries record every component of FDI flows. For most countries, data series on FDI capture only equity capital and intercompany debt; the majority of countries do not report data on the second component.9 There is evidence that the ‘retained earning’ component of FDI is positively related with the age of operation of firms in a given country, and that US MNEs have a general tendency to rely more on retained earnings for investment expansion than MNEs from other countries do (Lipsey 2000). Thus this problem of data coverage can lead to a considerable underestimation of the actual magnitude of FDI in a given host country, depending on the history of MNE involvement and the source-country profile of FDI. Even for the components on which data are available, the quality of data varies considerably across countries. For instance, some countries (such as China and Hong Kong) do not make an adequate distinction between portfolio investment and foreign direct investment. For these reasons, comparison of data among countries, and even over time for a given country, should be made with caution. Moreover, the data coverage tends to vary over time in a given country because of changes made to the data recording system.10 Table 2.1 provides data on gross FDI (in current US dollars) to developing Asian countries in a comparative global context. In Table 2.2 the same data are presented as a percentage of gross domestic fixed capital formation

27

128 541 105 019

6

23 515

7934

2854 370 12 197

308 0 156 114 1 34 7082

2620 2978

790

73 406 49 464

12

23 930

8686

1838 6458 6763

211 5 67 80 0 57 2693

772 1610

192

World Developed countries2 European transition economies3 Developing economies2 America and Caribbean Africa Middle East Developing Asia4 South Asia5 Bangladesh India Pakistan Nepal Sri Lanka East Asia and China6 China China, Hong Kong SAR China, Taiwan Province of 1154

16 028 4588

881 7 414 323 5 119 22 542

4322 2366 38 670

18 273

64 024

1572

205 098 139 502

1985–891 1990–941

1980–841

Economy

1996

1997

1998

1999

2000

2001

2002

2003

2004

6308

12 101

10 647

1559

37 521 6213

2962 2 2151 719 8 65 46 545

5587 3382 77 717

30 167

76 260

1864

41 726 10 460

3636 14 2525 918 19 133 56 069

2248

45 257 11 368

4962 139 3619 713 23 433 61 823

5790 10 849 5031 3371 90 006 100 925

50 246

222

45 463 14 765

3522 190 2633 507 12 150 65 503

9049 3262 91 459

82 540

117 544 151 746 191 764 186 626

4803

2926

40 319 24 578

3140 180 2168 530 4 201 77 265

11 886 1888 109 695

108 640

232 507

10 492

11 775

12 821

24 106

34 897

89 130

4928

40 715 61 924

3147 280 2319 308 0 173 116 162

4109

46 878 23 777

4113 79 3403 383 21 172 78 611

9627 20 027 3770 7100 141 955 101 483

97 523

1445

52 743 9682

4606 52 3449 823 6 197 67 205

12 994 5691 86 318

50 492

67 526

453

53 505 13 624

1898

60 630 34 035

5463 7153 268 460 4269 5335 534 952 15 10 229 233 71 928 104 890

18 005 18 090 6522 9840 94 755 137 705

46 908

253 179 217 845 155 528 166 337 233 227

9067

341 086 392 922 487 878 701 124 1 092 052 1 396 539 825 925 716 128 632 599 648 146 218 738 234 868 284 013 503 851 849 052 1 134 293 596 305 547 778 442 157 380 022

1995

Table 2.1 Foreign direct investment inflows, 1980–2004 (US$ million)

28

Share in global inflows (%) Developed countries Transition economies3 Developing economies America Africa Middle East Developing Asia

0.0

18.3

6.2 2.2 0.3 9.5

32.6

11.8 2.5 8.8 9.2

799 11 389 2427 732 3

1413 0 49 1733 360 14

0.0

0 442 1

0 293 0

81.7

4806 2

3860 3

67.4

568

1985–891

116

1980–841

Economy

Korea, Republic of ASEAN7 Brunei Darussalam Cambodia Indonesia Lao People’s Dem. Rep. Malaysia Myanmar Philippines Singapore Thailand Vietnam

(continued)

Table 2.1

8.9 2.1 1.2 18.9

31.2

0.8

68.0

4423 167 942 5181 1990 780

31 1691 23

15 235 7

756

1990–941

8.8 1.6 1.0 22.8

34.5

1.4

64.1

5815 318 1459 11 591 2070 1780

151 4346 88

28 201 583

1250

1995

12.8 1.5 1.3 22.9

38.6

1.6

59.8

7297 581 1520 9493 2338 1803

294 6194 128

30 301 654

2012

1996

15.6 2.2 0.7 20.7

39.3

2.5

58.2

6323 879 1249 13 586 3882 2587

168 4678 86

34 141 702

2640

1997

11.8 1.3 0.5 13.0

26.6

1.5

71.9

2714 684 1752 7472 7492 1700

243 241 45

22 434 573

5040

1998

9.9 1.1 0.2 10.0

21.3

1.0

77.7

3895 304 1725 16 624 6091 1484

232 1865 52

29 289 748

9448

1999

7.0 0.7 0.3 10.2

18.1

0.6

81.2