Chapter 7 Outline

Government Policy Instruments and FDI

Before tackling the important issue of bargaining between the MNE and the host government, we need to discuss the policy instruments that governments use to regulate FDI activity by MNEs. Both home (source) countries and host countries have a range of policy instruments that they can use. We will look at each in turn.

Home-Country Policies

Through their choice of policies, home countries can both encourage and restrict FDI by local firms. We look at policies designed to encourage outward FDI first. These include foreign risk insurance, capital assistance, tax incentives, and political pressure. Then we will look at policies designed to restrict outward FDI.

Encouraging Outward FDI

Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk. The types of risks insurable through these programs include the risks of expropriation (nationalization), war losses, and the inability to transfer profits back home. Such programs are particularly useful in encouraging firms to undertake investments in politically unstable countries.¹⁵ In addition, several advanced countries also have special funds or banks that make government loans to firms wishing to invest in developing countries. As a further incentive to encourage domestic firms to undertake FDI, many countries have eliminated double taxation of foreign income (i.e., taxation of income in both the host country and the home country). Last, and perhaps most significant, a number of investor countries (particularly the United States) have used their political influence to persuade host countries to relax their restrictions on inbound FDI. For example, in response to direct US pressure, Japan relaxed many of its formal restrictions on inward FDI in the early 1980s. Now, in response to further US pressure, Japan is moving toward relaxing its informal barriers to inward FDI. One notable beneficiary of this trend has been Toys "R" Us, which, after five years of intensive lobbying by company and US government officials, opened its first retail stores in Japan in December 1991. By the end of 1997, Toys "R" Us had 51 stores in Japan.

Restricting Outward FDI

Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time. One common policy has been to limit capital outflows out of concern for the country's balance of payments. From the early 1960s until 1979, for example, Britain had exchange-control regulations that limited the amount of capital a firm could take out of the country. Although the main intent of such policies was to improve the British balance of payments, an important secondary intent was to make it more difficult for British firms to undertake FDI.

In addition, countries have occasionally manipulated tax rules to try to encourage their firms to invest at home. The objective behind such policies is to create jobs at home rather than in other nations. At one time these policies were also adopted by Britain. The British advanced corporation tax system taxed British companies' foreign earnings at a higher rate than their domestic earnings. This tax code created an incentive for British companies to invest at home.

Finally, countries sometimes prohibit national firms from investing in certain countries for political reasons. Such restrictions can be formal or informal. For example, formal US rules prohibited US firms from investing in countries such as Cuba, Libya, and Iran, whose political ideology and actions are judged to be contrary to US interests. Similarly, during the 1980s, informal pressure was applied to dissuade US firms from investing in South Africa. In this case, the objective was to put pressure on South Africa to change its apartheid laws, which occurred during the early 1990s. Thus, this policy was successful.

Host-Country Policies

Host countries adopt policies designed both to restrict and to encourage inward FDI. As noted earlier in this chapter, political ideology has determined the type and scope of these policies in the past. In the last decade of the 20th century, we seemed to be moving quickly away from a situation where many countries adhered to some version of the radical stance and prohibited much FDI, and toward a situation where a combination of free market objectives and pragmatic nationalism seemed to be taking hold.

Encouraging Inward FDI

It is increasingly common for governments to offer incentives to foreign firms to invest in their countries. Such incentives take many forms, but the most common are tax concessions, low-interest loans, and grants or subsidies. Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI. They are also motivated by a desire to capture FDI away from other potential host countries. For example, as we saw in the opening case, the governments of Britain and France competed with each other on the incentives they offered Toyota to invest in their respective countries. In the United States, state governments often compete with each other to attract FDI. For example, Kentucky offered Toyota an incentive package worth $112 million to persuade it to build its US automobile assembly plants there. The package included tax breaks, new state spending on infrastructure, and low-interest loans.¹⁶

Restricting Inward FDI

Host governments use a wide range of controls to restrict FDI in one way or another. The two most common are ownership restraints and performance requirements. Ownership restraints can take several forms. In some countries, foreign companies are excluded from specific fields. For example, they are excluded from tobacco and mining in Sweden and from the development of certain natural resources in Brazil, Finland, and Morocco. In other industries, foreign ownership may be permitted although a significant proportion of the equity of the subsidiary must be owned by local investors. For example, foreign ownership is restricted to 25 percent or less of a airline in the United States.

The rationale underlying ownership restraints seems to be twofold. First, foreign firms are often excluded from certain sectors on the grounds of national security or competition. Particularly in less developed countries, the feeling seems to be that local firms might not be able to develop unless foreign competition is restricted by a combination of import tariffs and controls on FDI. This is really a variant of the infant industry argument that we discussed in Chapter 5.

Second, ownership restraints seem to be based on a belief that local owners can help to maximize the resource-transfer and employment benefits of FDI for the host country. Until the early 1980s, the Japanese government prohibited most FDI but allowed joint ventures between Japanese firms and foreign MNEs if the MNE had a valuable technology. The Japanese government clearly believed such an arrangement would speed up the subsequent diffusion of the MNE's valuable technology throughout the Japanese economy.

Performance requirements can also take several forms. Performance requirements are controls over the behavior of the MNE's local subsidiary. The most common performance requirements are related to local content, exports, technology transfer, and local participation in top management. As with certain ownership restrictions, the logic underlying performance requirements is that such rules help to maximize the benefits and minimize the costs of FDI for the host country. Virtually all countries employ some form of performance requirements when it suits their objectives. However, performance requirements tend to be more common in less developed countries than in advanced industrialized nations. For example, one study found that some 30 percent of the affiliates of US MNEs in less developed countries were subject to performance requirements, while only 6 percent of the affiliates in advanced countries were faced with such requirements.¹⁷

International Institutions and the Liberalization of FDI

Until recently there has been no consistent involvement by multinational institutions in the governing of FDI. This is now changing rapidly with the formation of the World Trade Organization in 1995. As noted in Chapter 5, the role of the WTO embraces the promotion of international trade in services. Since many services have to be produced where they are sold, exporting is not an option (for example, one cannot export McDonald's hamburgers or consumer banking services). Given this, the WTO has become involved in regulations governing FDI. As might be expected for an institution created to promote free trade, the thrust of the WTO's efforts has been to push for the liberalization of regulations governing FDI, particularly in services. Under the auspices of the WTO, two extensive multinational agreements were reached in 1997 to liberalize trade in telecommunications and financial services. Both these agreements contained detailed clauses that require signatories to liberalize their regulations governing inward FDI, essentially opening their markets to foreign telecommunications and financial services companies.

However, the WTO has had less success trying to initiate talks aimed at establishing a universal set of rules designed to promote the liberalization of FDI. Led by Malaysia and India, developing nations have so far rejected any attempts by the WTO to start such discussions. In an attempt to make some progress on this issue, the Organization for Economic Cooperation and Development (OECD) in 1995 initiated talks between its members. (The OECD is a Paris-based intergovernmental organization of "wealthy" nations whose purpose is to provide its 29 member states with a forum in which governments can compare their experiences, discuss the problems they share, and seek solutions that can then be applied within their own national contexts. The members include most European Union countries, the United States, Canada, Japan, and South Korea). The aim of the talks was to draft a Multilateral Agreement on Investment (MAI) that would make it illegal for signatory states to discriminate against foreign investors. This would liberalize rules governing FDI between OECD states. Unfortunately for those promoting the agreement, the talks broke down in early 1998, primarily because the United States refused to sign the agreement. According to the United States, the proposed agreement contained too many exceptions that would weaken its powers. For example, the proposed agreement would not have barred discriminatory taxation of foreign-owned companies, and it would have allowed countries to restrict foreign television programs and music in the name of preserving culture. Also campaigning against the MAI were environmental and labor groups, who criticized the proposed agreement on the grounds that it contained no binding environmental or labor agreements. Despite these problems, there is still a good chance that negotiations on a revised MAI treaty will restart soon.¹⁸