Staff Working Paper ERAD-99-02Revised November 2001
World Trade Organization
Economic Research and Analysis Division
The Impact of Transparency on
Foreign Direct Investment
1
Zdenek Drabek:WTO
Warren Payne:Economic Consulting Services, Inc.
Washington, D.C.
Manuscript date: August, 1999
Revised November 2001
Disclaimer: This is a working paper, and hence it represents research in progress. This paper represents the opinions of individual staff members or visiting scholars, and is the product of professional research. It is not meant to represent the position or opinions of the WTO or its Members, nor the official position of any staff members. Any errors are the fault of the authors. Copies of working papers can be requested from the divisional secretariat by writing to: Economic Research and Analysis Division, World Trade Organization, rue de Lausanne 154, CH-1211 Genève 21, Switzerland. Please request papers by number and title.
1
The Impact of Transparency on
Foreign Direct Investment
Zdenek Drabek* and Warren Payne
World Trade Organization Economic Consulting Services, Inc.
Geneva Washington, D.C.
*Views expressed in this paper are personal and should in no way be interpreted as official or representing the position of the World Trade Organization or its Member Countries. We are grateful, without implicating, Marion Jansen, Roberta Piermartini and two anonymous referees for helpful comments on the previous draft of the paper
ABSTRACT
Non-transparency is a term given in this paper to a set of government policies that increase the risk and uncertainty faced by economic actors foreign investors. This increase in risk and uncertainty stems from the presence of bribery and corruption, unstable economic policies, weak and poorly enforced property rights, and inefficient government institutions. Our empirical analysis shows that the degree of non-transparency is an important factor in a country's attractiveness to foreign investors. High levels of non-transparency can greatly retard the amount of foreign investment that a country might otherwise expect. The simulation exercise presented in the statistical part of this paper reveals that on average a country could expect 40 percent increase in FDI from a one point increase in their transparency ranking. Pari passu, non-transparent policies translate into lower levels of FDI and hence lower levels of welfare and efficiency in the host country's economy. A nation that takes steps to increase the degree of transparency in its policies and institutions could expect significant increases in the level of foreign investment into their country. This increased investment translates into more resources, which in turn increases social welfare and economic efficiency.
Key Words: Foreign direct investment, transparency, corruption, FDI modeling.
JEL Classification No. [F02] [F13] [F21] [F23] [M14]
1.Introduction
The issue of transparency in economic and business decisions has become one of the most talked about and novel topics in economics and finance and among businessmen and policy makers. Surely, economists and businessmen as well as government officials have always been aware that access to information may be impeded or costly or that business practices can differ from country to country - for better or worse. Nevertheless, it is only in recent years that transparency has become a major issue. The lack of transparency has been used by some observers as an argument towards redirecting foreign aid among countries. For example, in their study of foreign aid flows, Alesina and Weder (1999) show that foreign aid is not necessarily offered to the least corrupt governments. They further argue that donors should rethink their aid policies if they are truly serious about encouraging "good governance".
The lack of transparency has been also tied to the financial turmoil first witnessed in Mexico and later in Asia and other parts of the world. Following these financial crises, it is now widely recognized that the availability of timely and complete information is crucial in order to avoid the kinds of violent instability of financial markets that we have witnessed in recent years. It is no surprise, therefore, that M. Camdessus, the Managing Director of the IMF, thinks of transparency as the "golden rule" of the new international financial system.[1] Transparency has been proposed for the agenda of multilateral negotiations such as those in the OECD, and pursued as a powerful objective of influential non-governmental organizations such as Transparency International. Transparency in economic policy-making now also figures as an important condition for lending by international financial institutions. In sum, "transparency" has become the "buzz-word" of modern politics and economics.
In this paper we shall address one issue that has so far not received much attention in the discussion – the impact of transparency (or, rather, the lack of it) on flows of foreign direct investment (FDI). As we shall argue further below, there are strong reasons to believe that transparency in economic policy-making and in the activities of government institutions is vital in attracting foreign investment. If so, one would expect that countries with more transparent trade and investment regimes will attract more FDI than those that are plagued by the perception of bureaucratic inefficiencies and the existence of corruption and other related problems.
The main purpose of this paper is to evaluate the effects of transparent policy regimes on FDI inflows. In order to do so, we have developed a simple econometric model which we have tested with the help of standard statistical methods. The tests confirm our hypothesis that more transparent policy regimes indeed act as a strong incentive for foreign investors and vice versa.
The term "transparency" may be even currently somewhat "overused". It is often put forward out of context or without a specific meaning. This makes discussions about transparency too general and limits the scope for policy recommendations. We shall try to avoid committing the same error. Before plunging into the empirical analysis, we shall, therefore, examine the concept of transparency in more abstract terms. We shall first discuss various aspects of transparency as they are related to economic policy-making. In addition, we shall examine the reasons why transparency of policy regime is particularly important for foreign investors.
Why do we focus on FDI? The answer is very simple – FDI has become an increasingly more important factor of economic growth. This is reflected in the trend over the last several years as countries have increased reliance on FDI. Between 1986-1989 and in 1995 the rate of FDI grew more rapidly then world trade in goods. Between 1973 and 1995 the value of FDI multiplied by more than 12 times, from $25 billion to $315 billion, while the value of commodity exports multiplied by about eight and a half times, from $575 billion to $4900 billion.[2] In many cases the value of FDI flowing into a country exceeds the level of official government aid to that country.[3] In brief, while the value of international trade in goods is still far greater than the value of FDI, FDI plays an increasingly important role.
Developing and transition nations have a particularly strong interest in attracting foreign capital. Domestic savings are often insufficient in these countries to finance their investment needs. This capital shortage affects both public and private investment. The Asian Development Bank predicts that the demand for infrastructure investment in Asia alone will reach $150 billion annually by 2010.[4] The World Bank forecasts the need for investment between $1.2 and $1.5 trillion in infrastructure development in developing East Asian countries.[5] Foreign investment is also a key component of privatization schemes in transition economies in Central and Eastern Europe. The privatization process in the Czech Republic, Hungary, Poland as well as in countries like Slovakia, Bulgaria, and Romania, has actively pursued foreign capital.[6]
We shall organize the paper into 7 sections. The following section 2 introduces the topic by defining the range of issues which represent the origins of non-transparent economic policies. In the same section we shall also review the broad effects of non-transparent policies. In section 3 we shall asses the importance of transparency specifically for FDI. Measures to improve transparency will be discussed ion section 4. Section 5 represent the empirical part of this paper. It includes a discussion of methodology and provides a summary of the empirical findings, with more detail provided in the statistical appendix. Policy implications of our findings are discussed in section 6 and conclusions are presented in section 7.
2. Scope and Origins on Non–TransparentEconomic Policies.
The term transparency of economic policy is a catchall phrase that refers to the clarity and effectiveness of activities with impact on public policy. In the economic literature, the discussion about transparency has been mostly focussed on two key topics – corruption and bribery and on protection of property rights, but the issue is much larger as we shall now argue. Moreover, the literature has mainly been concerned with the activities of governments and their institutions. Even though we shall limit our empirical part of the paper to the same agent, this too is an oversimplification.
Let us start by considering the question of transparency in economic policy-making of governments. The lack of transparency has for us five different origins. First, economic policy – making will be seen as non-transparent if it is subject to corruption and bribery . By definition, bribery involves illicit payments which are never "advertised", or made otherwise public even though corruption may be sometimes so widespread that "everyone knows". Bribery is non-transparent not only because it is normally illegal but also because the non-transparency strengthens bargaining positions of the beneficiaries from these illicit payments. The impact of bribery can be economically highly distortionary. For example, in his work on the effect of corruption on government activities Tanzi shows that corruption distorts public investment (Tanzi et al.1997 and Tanzi 1999). Similar point is made by Mauro (1995) and (1996) who investigates the impact of corruption on various government expenditures and on public and private investment respectively. Corruption can also have highly detrimental effects on the country's distribution of income and worsens poverty (Gupta 1998) . Corruption and bribery have been also found to have an adverse impact on capital accumulation and may even threaten stabilization programs supported by the IMF (Asilis et al.1994). Further evidence of serious distortions has been provided in numerous World Bank studies such as those of D. Kaufman et al. (1999) as well as by other researchers.
The second important element of non-transparency arises in the area of property rights and their protection within a given country . The lack of copy right protection, the existence of patent infringement and lack of enforcement of contracts are all examples of what constitutes poor protection of property rights. The protection of property rights is vital for firms to pursue new investment and research in order to ensure that firms will see return from their investments[7]. Without this profit incentive there is little motivation to take risks and invest. In addition, weak property rights result in the distribution of assets as common property, and as is well known, common property situations may result in sub-optimal allocation of assets.[8] This could be a particularly serious problem for countries that are undergoing fundamental changes of their institutions and, in general, for developing countries. The questions of property rights have been examined extensively in the literature including issues related to investment behavior of firms. Developing countries are particularly susceptible problems related to the protection of intellectual property rights. For example, a recent study of National Economic Research Associates shows that developing countries benefit a great deal from instituting a stronger protection of intellectual property rights. [9] A study of Weimer (1997) also makes essentially the same point when it argues that political systems can have significant impact on the credibility of commitments on property rights, with a special focus on post-communist nations.
The third and fourth aspects of non-transparency relate to the level of bureaucratic inefficiency within the government and poor enforcement of the rule of law. These two factors can pose severe barriers to business. If the quality of government service is unpredictable, companies' exposure to additional risks is increased. Moreover, their ability to cover against these risk impeded due to the unpredictable nature of government service. OECD (1997b), for example, shows that bureaucratic inefficiency and weak rule of law impede economic activities by imposing additional costs on economic agents. Delays in licensing, the inability of the courts to enforce contracts and the capricious and arbitrary enforcement of rules and regulations all reduce economic efficiency and effectiveness.[10]
Finally, the fifth origin of non-transparent economic policies has a great deal to do with the conduct of economic policies per se. Economic policies are likely to be treated as non-transparent if they are subject to unpredictable policy reversals. These policy reversal are particularly damaging in privatization deals and whenever foreign investors are involved. Consider, for example, the case of privatization in country X in which the government summarily cancels decisions of the previous government to privatize the country's industry. The reaction of foreign investors to the policy reversal is likely to put the country concerned "off-limits" for foreign investors. Unfortunately, this is not a hypothetical case as we have seen in recent years in a number of countries which range across different regions and cultures such as Indonesia, Nigeria or Slovakia. In each one of these countries, the lack of transparent policies has been suggested to be one of the main reasons why foreign investors have demonstrated extreme caution to invest and for capital flight. This reflected a growing suspicion of investors about the intentions of governments concerned and their commitments to policies in the countries concerned.
Related example on non-transparent economic policies is one in which economic decisions are perceived to be arbitrary. Absence or poorly executed tenders for sales of assets is a relevant case in point. It is clear that for tenders to be perceived to be transparent they must be based on rules, and these rules must not be ambiguous and, once accepted, they must not be changed except in exceptional circumstances. Moreover, if exceptions are to be permitted these must be well understood and known to all participants in advance.
Who is guilty? But the issue of transparency is, of course, much wider. Bribery and corruption, for example, are not necessarily the "privilege" of governments only but they have "infected" even private businesses in some countries. Moreover, lack of transparency has been criticized in the case of institutions that play an important role in the provision of public information - and thus in the conduct of public policy – and they are not government institutions. Take the case of rating agencies that provide credit ratings of governments, private businesses and other institutions. These agencies play a crucial part in influencing investors' decisions with their credit assessments even though, as some would argue, they are not subject to the strict scrutiny of markets or regulators. In recent discussions of the Basle banking criteria, Financial Times complained that " markets and regulators should keep a closer eye on the record of rating agencies and demand greater transparency from them". [11]
International organizations have also recently become targets of public criticism. Following the "Mexico crisis", the International Monetary Fund has been under attack by their critics about its practices of keeping certain information out of the public domain or not providing information faster to the public.[12]. As a result of this criticism, the IMF has been revising its policies concerning the release of economic and financial information on individual countries in order to make its own practices and countries' economic conditions more transparent. The pressure is also on other economic and financial multilateral institutions. For example, a recent meeting of a committee on technical barriers to trade of the World Trade Organization has suggested that " information regarding current work programs and proposals (on international standards) … should be made easily accessible and comprehensible to all interested and related parties".[13]
It must be also recognized that the question of transparency can go even beyond individual economic agents – such as firms, governments, public policy institutions or even individual governments. Take, for example, the case of the ongoing discussions about international financial "architecture". One of the recent proposals was to ensure that the International Monetary Fund should be in the position "to give moral and financial support to countries imposing capital controls or suspending debt repayments".[14] The idea is not to help countries in distress but also "to guide expectations by providing a transparent and timely explanation of why a particular approach to a private sector involvement was taken"[15]. Clearly, for this proposal to be workable, this can only be if it is agreed by the major shareholders of the IMF. This cannot be a proposal of a single government but it must be the outcome of international cooperation. The fact that the proposal was indeed made by the finance ministers of the Group of Seven countries gives it a far better chance of acceptability.
In brief, the concept of transparent economic policy-making is very broad and needs to be considered in its entirety if economic policies are to be seen as truly transparent. Nevertheless, our own treatment of the subject will have to be narrower. We shall only consider those aspects of transparency that relate to government policies and of activities carried out by government institutions. The reason is a matter of expediency rather than of theory. Our choice has been to some extent determined by the constraints of our empirical tests which in turn have been influenced by the availability of data.
In addition, for many reasons governments tend to be most implicated as the origin of corruption and in the lack of transparency Economic policies and activities of government institutions can be perceived as transparent if the actual policies reflect their actual design in that they transmit the intended messages and signals. Similarly, economic institutions can be treated as transparent if their activities exactly conform to the stated objectives of these institutions and they carry out activities fully consistent with these objectives. Moreover, for economic policies and government institutions to be transparent it must be, of course, assumed that economic policies are clearly formulated, and that government institutions do have clear objectives and mandates. In brief, governments affect transparency through activities that they themselves control – regulatory activities, public sector policies and other. Thus, our focus on governments is given partly by technical reasons and partly by the important role of governments as an economic agent.