IFIs on trade and investment: Liberalisation bias returns

30 September 2010

Guest analysis by Aldo Caliari, Center of Concern

The World Bank’s latest report on foreign investment and its new trade strategy are part of a worrisome trend that involves the Bank’s growing use of tools other than conditionality to restrict the space for countries to pursue alternative, country-tailored development strategies.

In early July, the World Bank launched Investing across borders, a report that, in the words of the Bank, “offers objective data on laws and regulations affecting foreign direct investment across 87 countries.” The report, which will be updated every year, covers indicators for these countries in four areas: investing across sectors, starting a foreign business, accessing industrial land and arbitrating commercial disputes. The report contains disclaimers about the need to read its findings with caution, outlining that the indicators are “only partial measures of the topics they cover” and that “circumstances in each economy must be considered when interpreting the indicators and their implications for policies and the investment climate.”

The Bank lays out, at the end of the chapter on each indicator, a set of “good practices” with a heavy bias towards the liberalisation of foreign investment. For instance, some of the top recommended practices emerging from the report are: “equal treatment of foreign and domestic investors”, including in their right to acquire and own land (see Update 72); adherence to and implementation of conventions on arbitration such as through the Bank-based International Centre for Settlement of Investment Disputes (see Update 66); and the “simplification of the establishment process” for foreign investors.

If previous experience is any guide, the “naming and shaming” impact of the report on countries not implementing such “good practices” is likely to be much stronger than the disclaimers might lead one to think. The publication follows in the footsteps of the Doing Business report, a yearly compilation of indicators comparing countries’ business regulations that the Bank started publishing in 2003 (see Update 66, 62, 57, 53). The recognition of important methodological shortcomings in Doing Business (see Update 67) did not prevent the Bank from releasing a new ranking based on its indicators in 2010. The ranking has become quite influential: in 2007, the Bank proudly reported that the report had inspired 48 reforms around the world. Soon after Doing Business was launched, the Bank’s low-income country arm, the International Development Association, began to use performance on some of the indicators to influence the allocation of grants and cheap loans.

Yet, the Investing Across Borders project represents a leap for the Bank from Doing Business because the policy framework towards foreign investment is very sensitive for all states, particularly developing countries. When issuing its Doing Business report the Bank was conscious of ensuring its rhetoric would not be seen as supportive of foreign direct investment (FDI) liberalisation. Doing Business was, thus, dressed up as a ‘microeconomic’ exercise that shed light on best business environment practices for small companies, neutral to whether they were local or foreign. But the Investing Across Borders report has no qualms in openly advocating in favour of foreign investors. The indicators are underpinned by the assumption that, when it comes to FDI, more is always good.

Contrary to evidence

Researchers have found that whether FDI is beneficial to the host economy depends on a number of issues, such as whether FDI raises production costs and lowers profitability for domestic firms, the extent of positive spillovers and linkages for domestic firms, the likelihood of import dependence and profit repatriation, and so on. In its 2005 Economic development in Africa report, the UN Conference on Trade and Development warned that avoiding such questions “in favour of easy recipes of rapid liberalisation in the hope of attracting FDI will neither achieve economic development goals nor maximise potential gains from hosting it.”

The empirical research is also quite mixed, to say the least, on the role that the “ease of doing business” has in foreign investors’ consideration of a host location as compared to factors such as the quality of infrastructure, size of markets, size of the economy or rate of growth, current account balances, not to mention interest rate and exchange rate differentials. Thus, the mere dismantling of barriers to foreign investors can have limited or no effect on the ability of countries to attract more FDI.

Lack of alignment between the model it advocates and experience may not constrain the Bank. At one point in the report, the Bank finds that countries in Asia, the most economically dynamic part of the developing world, show the most limited openness to foreign equity ownership. A full box is devoted to brush aside such an “odd fact.” Likewise, the Bank seems unprepared to draw any conclusions from its own finding that the imposition of land ownership restrictions on foreigners – contrary to one of its good practices – is a feature of many high-income economies.

Trade strategies ideological

The same refusal to reconsider long-held assumptions also pervades the Bank’s approach as it develops a trade strategy (see Update 71). The strategy is expected to be approved by the Bank’s executive board late this year and will represent the point of reference for Bank staff and management on trade issues in the future.

In a March pre-strategy background paper for consultations, the Bank makes the important recognition that “the crisis has called into question export-oriented growth strategies” and “raises concerns that international integration exposes developing countries to excessive external economic shocks, leading to fluctuations in their economic growth.” It goes on to suggest, however, that countries should improve the incentive frameworks shaped by their own tax and tariff policies, “such as through special economic zones or reforms to reduce the anti-export bias of the overall incentive framework.” The steering committee of the International Working Group on Trade-Finance Linkages, an NGO coalition, said, “coming out of a crisis that was weathered best by countries that were able to rely on domestic markets, this would be an unfortunate misreading of history.”

The reference to an “anti-trade bias” is also found in a recent IMF staff position note analysing trade in low-income countries: “This bias reflects moderate to high average levels of protection, and uneven and unstable tariffs, trade-related taxes, and other trade-related policies.” The Fund staff’s sweeping recommendation is to lower tariffs to a maximum of 25 per cent and an average of 15 per cent. Not content with that, it says “further tariff rate reductions would be even more beneficial.”

Strongly underpinning the Bank proposals on trade seems to be the view that the emergence of production-sharing networks means that “low transaction costs and favourable business enabling environments have become more important sources of comparative advantage.” However, the experience of countries that used trade to develop shows they did it on the basis of a dynamic notion of comparative advantage. Indeed, full use of tools to manage the rate and patterns of investment into export sectors was key to their progress. Interestingly, none other than World Bank chief economist Justin Lin has recently defended the need for states to take deliberate steps to upgrade their productive capacities and over time change their initial comparative advantage. This sounds very different from the passive approach of competing on the basis of lower cost and reduced regulations that the IMF and the Bank strategy suggests.

Sadly, should the Bank succeed in its intense advocacy of indiscriminantly reducing barriers to all foreign investment, developing countries’ ability to use trade in their interests and upgrade comparative advantages may become a thing of the past.