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A fresh look at FDI: Is it quantity or quality?
We are too often tempted to conclude that Foreign Direct Investment (FDI) always leads to or stimulates economic growth
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e are too often tempted to conclude that Foreign Direct Investment (FDI) always leads to or stimulates economic growth. By holding a general consensus on the positive influence of FDI on growth, the government formulates many seductive incentives in order to earn induce FDI.
In fact, despite controversial results on the issue, in most cases, the evidence shows that the impact of FDI on growth depends on its quality, not its quantity.
Prasad, Rajan and Subramanian (IMF, 2007) examined the impact of foreign investment on growth in 51 non-industrial countries by using current account balances as a measure of total external capital financing available for a country.
Theoretically, current account balances show the difference between national savings and national investment and thus, indicate the total amount of foreign investment. Surprisingly, they find a positive correlation between growth and current accounts. That means developing countries that have relied less on foreign finance have grown faster over the long run.
In regards to that paradox, Amartya Sen, a 1998 Nobel Prize Laureate in Economics, argued that FDI in some sense was not a value in itself and an economy could not solely depend on it for progress.
So, the quality of FDI is the critical factor. But, how do we measure the quality of FDI?
UNCTAD's World Investment Report 2006 describes 'quality FDI' as 'the kind that would significantly increase employment, enhance skills and boost the competitiveness of local enterprises'. More specifically, high-quality FDI causes technical spillover effects and increases in added-value.
With limited sources for domestic financing, President Joko 'Jokowi' Widodo's administration aims to reform Indonesia's economic structure into an industrial-based economy. Therefore, apart from quantity, the Indonesian government should put more effort into attracting high-quality FDI.
So, what kind of strategy would be best to attract high-quality FDI? Let's consider the case of Ireland.
In 2005, IDA Ireland, an Irish investment promotion agency, deployed ¤70 million to establish the National Institute for Bioprocessing Research and Training (NIBRT). Though it was the most costly project of that year, I would emphasize another brilliant angle to all of this: the timing.
Despite experiencing negative shocks in FDI in 2004/2005 due to external factors, the Irish government consistently showed its commitment to inviting high-quality FDI into the country. As a result, the facts speak for themselves. Now Dublin is known as the European headquarters of Google, Facebook and LinkedIn. Also, according to IBM's 2015 Global Location Trends report, Ireland has been named as the top-ranking destination by quality and value of investment for four years in succession.
There are different stories in other countries, but to summarize, there is no single best policy that works for every country at any time to attract high-quality FDI.
Fortunately, however, empirical evidence offers a clue to attracting high-quality FDI: A high level of human capital is paramount, complemented by developed financial markets, adequate infrastructure and good institutions.
The study by Borensztein, De Gregorio and Lee (1998) and Alfaro & Charlton (2007) support the conclusion that the positive relationship between FDI and growth is particularly strong for industries with high-skill requirements, where the exploitation of technology and innovation spillovers run more quickly.
Therefore, to make Indonesia more attractive for high-quality FDI, over the coming decade, policies should be directed toward improving education in order to provide a highly skilled workforce.
Also, the government should spur public investment in infrastructure projects (specifically electricity and transportation). In order to distribute the benefits of FDI equally across the nation, improvements in the aforementioned sectors should be prioritized outside of Java.
Simultaneously, government and relevant authorities should formulate new strategies to accelerate financial expansion and eliminate corruption. The capacity of institutions should be elevated in order to produce effective regulations and to strengthen the rule and consistency of law.
Competition will lead to technological improvement and gains in innovation and productivity. These are all essential to generating increasing returns to scale that will push Indonesia's economy to a higher growth trajectory and help to avoid the risk of a middle-income trap.
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The writer is an economic analyst at Bank Indonesia. The views expressed are his own.
