The need to regulate foreign investment

The major issue of the Multilateral Agreement on Investment (MAI) is not whether foreign investment is good or bad, or should or should not be welcomed. The real issue is whether or not national governments should retain the right and power to regulate foreign direct investment (FDI) and to have the adequate authority and means to have policy instruments and options over investment, including foreign investment.

by Martin Khor

MOST countries presently accept the importance of foreign investment and are trying their best to attract foreign investments. However, there is evidence that foreign investment can have both positive and negative effects, and a major objective of development policy is to maximise the positive aspects whilst minimising the negative ones, so that, on balance, there is a significant benefit. Experience shows that for foreign investment to play a positive role, the government must have the right and powers to regulate its entry, terms of condition and operations.

The key problem is that the approach taken in the proposed MAI would remove these government rights and power. By doing so, the negative aspects of unregulated and uncontrolled foreign investment inflow and establishment could overwhelm the positive aspects.

Most developing countries now have policies that regulate the entry of foreign firms, and include various conditions and restrictions for foreign investors overall and on a sector-by-sector basis.

There are few countries (if any) that have now adopted a total right-of-entry policy. In some countries, foreign companies are not allowed to operate in certain sectors, for instance banking, insurance or telecommunications. In sectors where they are allowed, foreign companies have to apply for permission to establish themselves, and if approval is given, it often comes with conditions.

Of course, the mix of conditions varies from country to country. They may include equity restrictions (for example, a foreign company cannot own more than a certain percentage of the equity of the company it would like to set up) and ownership restrictions (for instance, foreigners are not allowed to own land or to buy houses below a certain price).

Local companies

Many developing countries also have policies that favour the growth of local companies. For instance, there may be tax breaks for a local company not available to foreign companies; local banks may be given greater scope of business than foreign banks; and local firms may be given preference in government business or contracts.

Governments justify such policies and conditions on the grounds of sovereignty (that a country's population has to have control over at least a minimal but significant part of its own economy) or national development (that local firms need to be given a 'handicap' or special treatment, at least for some time, so that they can be in a position to compete with more powerful and better-endowed foreign companies).

Most developing countries would argue that during the colonial era, their economies were shaped to the advantage of foreign companies and financial institutions (belonging usually to the particular colonising country).

Local people and enterprises were therefore at a disadvantage, and now require a considerable length of time where special treatment is accorded to them, before they can compete on more balanced terms with the bigger foreign companies.

This has been the central rationale for developing countries' policies in applying restrictions or imposing conditions on foreign investments.

The MAI proposal to liberalise foreign investment flows in so comprehensive a manner will therefore have serious consequences. For if the proposals are adopted, governments in developing countries will find that the space for them to adopt their own independent policies on how to treat foreign companies and investments will be very severely restricted.

No longer will each government have the freedom to choose its own particular mixture of policies and conditions on foreign investments. The major policies would already have been determined by the multilateral set of investment rules, and the choice available would be very much constrained to more minor aspects.

Need to protect the balance of payments and promote domestic development
One of the most important effects of the MAI would be that governments will find it much more difficult to control the balance of payments, and especially to take measures to get out of BOP deficit problems.

One of the most important disadvantages or dangers of foreign investment is that it has a tendency to lead to a net outflow of foreign exchange and thus have a negative effect on the BOP. This is why government policies to regulate foreign investment are so important.

In South-East Asia, countries like Malaysia, Thailand, Indonesia and the Philippines are now facing large deficits in the BOP current account. On further analysis, it is found that the large inflows of foreign investment have contributed significantly to the deficit.

Take the case of Malaysia. The BOP current account deficit rose from RM7.4 billion in 1993 to RM17.8 billion in 1995 (9% of the GNP), causing great concern in the country. The main reason for this rising deficit was the increase in foreign investment:

  • Firstly, there was a jump in the imports of capital goods and intermediate goods by foreign investors and this had a negative effect on the merchandise trade balance. According to the Deputy Finance Minister: 'The rise in the trade deficit (in 1995) is mainly due to an increase in the import of capital goods brought in by foreign investors. If not for foreign investments, in 1995, Malaysia would have recorded a large excess in the trade account.' He said foreign investment rose 26% in 1995 to RM20 billion, and imports of capital goods through these investments accounted for RM18.5 billion.

  • Secondly, there has been a high and fast increase in the profits and dividends repatriated by foreign investors. As the stock of FDI rises, the stream of 'investment income' flowing out also increases rapidly. In Malaysia, the weakness of the BOP is the large deficit in the services account. In 1995, the deficit was RM18.8 billion or 9.4% of GNP. (In 1990, it was only RM9.7 billion.) Of this, RM13.4 billion was gross investment income of foreign companies. This was about 7% of GDP value. According to Malaysia's top economic planner, Economic Planning Unit director-general Tan Sri Dato Seri Ali Abdul Hassan Sulaiman, 'outflows for investment income payments (particularly repatriation of profits and dividends for foreign-owned companies) is the single major contributor' to the services account deficit.

In order to counter the impact of profit outflow, one can persuade the foreign company to reinvest its profits in the country. This, however, does raise the question: if there is further reinvestment by foreign firms, this will lead to a higher stock of foreign capital and thus a higher future stream of profits and dividends, which eventually may be repatriated. If so, there is the dilemma of reducing the present effects of the profit outflow but having to face the potential of even higher streams of profit outflow in the future. The problem is thus not solved but postponed, and to a potentially higher level.

Foreign exchange outflows

The more permanent solution is to ensure that foreign investment in the country overall is of a character that does not cause large foreign exchange outflows in net terms. For example, foreign firms that export a large part of their products are more welcome. Or else firms that apply to enter can be given permission only if they abide by conditions that their investments do not lead to high foreign exchange losses, for example, by exporting enough of their products, and by limiting their imports through using local inputs.

In general, foreign companies that enter a country in order to exploit its market (and therefore do not export so much), and, in doing so, displace products or services previously provided by local firms, have a greater tendency to generate foreign exchange loss and BOP problems. Countries with a large market like China or India will face this problem more, because foreign companies are attracted to the large population and the local market there, and so a large part of these companies would want to produce for the local market rather than for export.

In any case, the most important principle is that developing countries need to have the authority to regulate the entry and terms of operations of foreign investment, for the sake of their development objectives and to protect their economy and society, for example, to protect the BOP.

To strengthen the BOP, governments require the authority and option to: (a) regulate foreign investment; (b) reduce imports of goods and services; (c) promote exports of local firms and services. These options are already being severely curtailed by the new Uruguay Round rules in the WTO. The MAI would make the situation worse.

In the past and at present, governments have placed conditions that firms must use specified local inputs, or that a percentage of the output value must be locally sourced (local-content policy). Another condition is that imported inputs of a firm must be restricted to only a certain percentage of that firm's export earnings (balancing-of-foreign-exchange policy). Another policy may be to restrict a commodity or product from being exported (by imposing a ban or limiting export to a certain percentage).

All these three policy measures have been explicitly mentioned in an illustrative list and made illegal by the Trade-Related Investment Measures Agreement (TRIMs) of the Uruguay Round, on the ground that they discriminate against foreign products or foreign trade. Of course, the removal of these policy measures would make it more difficult to resolve BOP deficits. Developing countries have five years (from January 1995) to implement this. In these negotiations, it may be possible to reopen the issue of the fairness of such prohibitions.

The MAI would make the situation worse. Governments now control the quantity and quality of foreign investment, and can limit the percentage of foreign equity, preferring joint ventures so that a share of the profits is retained by locals. Some countries limit the outflow of profits. These measures would be outlawed. Inability to regulate entry will increase the foreign share of equity. Removal of joint-venture arrangements would further raise foreign equity. Together, these would raise the foreign share of profits in the economy. Given international trends, corporate tax is being progressively reduced. If foreign profit outflow is too high and can threaten the BOP or reserves and financial stability, the option of limiting profit repatriation would not be available.

Measures to reduce imports or use of foreign services, and measures to increase the use of local products, services and facilities, are important policy measures to reduce BOP deficits and to develop the economy. The enhanced disciplines in the WTO already make this more difficult. The investment treaty would make it even more so.

Under the Services Agreement (GATS) in the WTO, national treatment is to be given to those sectors which are put on offer by a country. In other words, there cannot be measures discriminating in favour of local services, facilities or enterprises.

For instance, if shipping is on the offer list, then measures supporting local shipping lines may be considered WTO-illegal. According to the trade journal Straits Shipper, foreign countries are already protesting Malaysia's introduction of fiscal incentives to shippers to claim double tax deduction on freight charges paid to Malaysian shipping lines. The EU and US view this as discriminating in favour of national ships and violating the new trade regime.

Fortunately, the Services Agreement is not a catch-all agreement and applies only to those sectors or activities that the country has put 'on offer'. The proposed MAI would be a catch-all agreement, in which all sectors and activities are included, unless specifically excluded. Thus, any 'affirmative action' measure that promotes local industries or services (through subsidies, preferential tax treatment, specified condition for investment, even R & D subsidy) could be seen as 'discriminatory' against foreigners and thus prohibited.


There is an important role for foreign investments in developing countries. But this role can be positively fulfilled only if governments retain the right to choose the types of foreign investments and the terms of their entry and operation.

Thus, the objection to the treaty is not out of any bias against foreign investment per se. Rather, it is because of the successful experience of those countries that have made use of foreign investment that there is a realisation of the importance of the need for governments to have decision-making powers and policy options over the entry, terms of equity and operations of foreign investments.

For example, Malaysia has had a very sophisticated system of combining liberalisation with regulation in a policy mix that can be fine-tuned and altered according to the country's economic condition and development needs. The ability and right to have options for flexible policy was especially needed to redress social imbalances among ethnic communities in the country. Without the application of such a policy, it is doubtful the country could have attained the social stability that underlay the high growth of the recent past. In 1970 (13 years after independence), the foreign share of equity was still 70%, the share of the majority Malay community, with 55% of the population, was 1% and the share of non-Malay citizens was 22%. Due to a development policy that was based on requiring foreign companies to enter on a joint-venture basis - with 50% equity to locals and of that, 30% to the Malay community - the share of equity has changed dramatically as a result of differential shares of growth going to different communities. The foreign share is now around 35%, the Malay share has grown from 1% to 20%-30% and the non-Malay citizen share is about 25%. Such a policy outcome would not have been possible if there had been the constraints of an MIA or MAI.

There must be many other examples in other countries demonstrating the need for policy instruments and options over investment policy to meet development, economic, social and political-stability goals.

Thus, from experience, developing countries need to maintain the right and option to regulate investments and have their own policy on foreign investment, instead of an international investment regime that would reduce or take away those rights. Giving total freedom and rights to foreign investors may lead to the disappearance of many local enterprises, higher unemployment, greater outflow of financial resources, and, therefore, to BOP problems. It may also worsen social imbalances within society, thereby causing social instability which will offset economic prospects.

The MAI and the MIA are not the only models for establishing relations between foreign companies and host governments. Another approach was earlier attempted in the draft UN Code of Conduct on Transnational Corporations, in which the rights and obligations of foreign companies and host governments were spelled out. Efforts to establish this Code of Conduct were finally killed off in 1992. However, the draft is still useful as an example of a different approach.

Striking a proper and fair balance between foreign investors and host countries, who have different goals and interests, is important. Investors from foreign countries want to come to developing countries for three main reasons. First, they apprehend that the return on capital in their home country is not adequate; second, they want to combine their capital with the cheap labour of the host country to reduce the cost of production; and third, they want to utilise the raw materials of developing countries near their source.

The host developing countries, on the other hand, are interested in: (i) development of their services and infrastructure which may help their industrialisation and development; (ii) production of exportable goods, and (iii) continuous technological development in their industrial production and services.

These two sets of objectives are not incompatible. And the interests of foreign investors and host governments, although different, may be harmonised. But it is critical that any FDI meet both sets of objectives.

From the point of view of a developing country, the government must have the right and power to determine the entry and conditions of foreign companies, so that the country's development objectives can be fulfilled. The MAI would cause a great imbalance in the relation between the host country and the foreign investor. Thus, in its present form, it would be unwise for developing countries to enter into such an agreement. - (Third World Resurgence No.90/91, Feb-March 1998)

Martin Khor is the Director of Third World Network.