No short-cut in investing for sustainable development

Mike Pfister News & Analysis Policy & Development

In July 2015, Addis Ababa offered the platform for world leaders to affirm their “strong political commitment to address the challenge of financing and creating an enabling environment at all levels for sustainable development in the spirit of global partnership and solidarity”1. This challenge is twofold and can be understood through an input-output framework: securing the financing (input) and ensuring its contribution to sustainable development (output). While there is consensus around the broad lines of such a framework, a central question remains unanswered – how can the output be generated from the input?

If one considers a frequently used definition of sustainable development as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs”2, which has further been categorized into economic, social and environmental components, one quickly grasps that the equation is complex. In short, one policy dimension on its own, say taxes, cannot finance sustainable development. It is the interplay of a wide array of policies and their implementation that can provide an enabling environment for generating the needed domestic resources.

Investment, both private and public, domestic and foreign, can and should play a critical role in this regard – especially as official development assistance (ODA) will far from cover the financing needs. Countries must, however, strengthen their capacities to trigger the development impact of these resources to ensure financing for sustainable development seeds grows locally – this is where catalytic ODA is much needed. This also extends to highly technical areas, such as the quality of tax administration, which should significantly contribute to the public revenues from taxes raised from the activities of investors. These revenues can support critical sustainable development vectors, including education, health and infrastructure. However, economic activity, such as investment, is the basis for any dynamic tax system. As one can see, it all boils down to domestic frameworks. In times of an uncertain global economy, investors – who can bring much-needed capital, technology and know-how – tend to take an even harder look at the latter.

Regulations and good legal capacity can encourage investors
Getting the factors of an enabling environment to a stage where they are conducive for investment is complex. This ranges from core investment policy per se to areas such as infrastructure, public governance, education and skills, to of course other interlinked economic policy dimensions, like environmental policy and trade. The quality of investment-related policies directly influences the decisions of all investors, be they small or large, domestic or foreign. In fact, even public investment is affected by the environment for private investors. The former also depends on good quality institutions, qualified staff and good governance for effective delivery.

Transparency, property protection and non-discrimination of investors are investment policy principles that underpin efforts to create a sound investment environment for all. Laws and regulations dealing with investment and investors, including small and medium enterprises, must be clear, transparent and readily accessible without imposing unnecessary burdens. A policy of timely, adequate and effective compensation for expropriation, consistent with international investment law, is also a pre-requisite for most investment. In the case of foreign investment in particular, discriminatory restrictions on international investment (such as limits on ownership by foreign companies in certain sectors of the economy) can be substantial obstacles. While most countries have reduced these restrictions substantially, some persist in industries across the globe. These restrictions should be transparent and be periodically reviewed to assess their costs against their intended benefits.

For example, ex-ante screening of investment inflows by governments can limit investment, especially when it is not transparent. While the majority of OECD countries have significantly reduced their screening of investment3, the picture across developing and emerging economies is mixed. Zambia, for example, has a largely open investment regime with limited screening; Myanmar, on the other hand, has a stricter screening mechanism through the Myanmar Investment Commission. Although socio-economic conditions may seem to justify more centralized approaches, particularly when line ministries are still developing their capacities to effectively manage investment approval mechanisms, the efficiency of the system should be kept intact. Centralized investment screening can unduly stretch the capacity agencies, constraining their ability to effectively manage increasing investment flows. This can result in a focus on big investment projects, to the detriment of smaller investments that could bring a number of development benefits beyond employment, including new technology and know-how.

Good laws, and the capacity to enforce them, are fundamental

Particular attention must also be paid to an efficient legal system with good enforcement. For example, while many countries have laws and regulations to protect intellectual property rights, they often lack effective enforcement mechanisms. This can discourage innovation and technology transfer from larger foreign investors to local suppliers and partners. Systems of contract enforcement and dispute resolution are also important in keeping possible disputes from escalating, with high potential costs for the host government. Indeed, delegating an investment dispute to the International Centre for Settlement of Investment Disputes (ICSID) entails heavy administrative and arbitrator fees, as well as a variety of other costs (such as attorneys’ fees, expert and witness costs, etc.) incurred all the way through to the final arbitration award.

The capacity of the domestic legal system is of critical importance to the overall enabling environment for investment. Over the past decades, international investment agreements, including bilateral investment treaties and free-trade agreements, have been used to strengthen investment ties among countries, including developing countries. Developing countries need to be aware of the benefits and risks of entering such treaties, and to ensure they have adequate capacity to negotiate and implement them, all while ensuring consistency with the domestic legal systems.

Timely, secure and effective methods of registering ownership of land and other forms of property is also crucial. In many African countries, the absence of accurate and comprehensive land registration systems considerably lowers the incentives for landowners to register their plots and to make long-term investments and upgrades in their property; in Tanzania, for instance, only 2% of land is currently registered4. The insufficient transparency or coherence of land compensation systems is another considerable deterrent for domestic and foreign investors alike. Land administration is often subject to a mixture of community, tribal and common law, and application procedures can vary from one land authority to the next within the same country.

Capitalizing on investment for sustainable development

For any country, attracting investment is a challenge of its own; benefiting from it is another. To be effective, measures to attract investment must anticipate potential market failures (such as inadequate supportive infrastructure, costly and lengthy business establishment procedures, low competitiveness in domestic markets, etc.) and be developed in a way that will leverage the strong points of a country’s investment environment. This involves both promotion and facilitation – two very different sets of activities. The former is concerned with promoting a country or a region as an investment destination while the latter is about making it easy for investors to set up shop or expand their existing investments. The importance of good and appropriate investment promotion and facilitation cannot be underestimated; in fact, poorly designed investment promotion and facilitation measures can be costly and ineffective and limit benefits to development.

Investment promotion can play a critical role in developing countries’ economic performance and most developing countries have established dedicated investment promotion agencies. Many of these agencies are highly dynamic and internationally active, such as the Mauritius Board of Investment, which has representations in key markets where foreign investors are targeted. The underlying principle of good promotion, however, is that it can only be as effective as the quality of investment-related policies.

Southeast Asia is often hailed as an example for the promotion and attraction of export-oriented foreign direct investment – one that many African governments look towards to inform their own investment attraction efforts. Such policy measures have allowed countries like Malaysia and the Philippines to shift quickly towards a manufacturing-based economy through foreign direct investment in which economic growth was driven by rapidly expanding exports. The record from this export performance speaks for itself, but so too does the manifest failure in many cases to translate this success into something more durable. Not only have exports been limited to a small number of products (usually intermediate goods) and sectors, but also these exports are often produced in virtual foreign enclaves with limited linkages with the host economies. This is a particular risk when export development is concentrated within special economic zones or export processing zones. Unless careful attention is paid to fostering upstream and downstream business linkages between these high-growth sectors or zones and the rest of the economy, there are often limited returns for the host country.

To make the most of foreign investment inflows, developing countries need to promote investment linkages between foreign affiliates and local enterprises and to address specific investment obstacles faced by small and medium-sized enterprises. In many countries, such linkages are addressed on an ad-hoc basis, without dedicated capacity development to help domestic companies find business opportunities. For instance, foreign investors may be obliged to sub-contract a minimum share of work to domestic firms; or domestic entrepreneurs may be given price preference margins when bidding for sub-contracts and public procurement contracts. In the longer term, such measures are often self-defeating. For countries that do use them, it remains important to carefully structure such preference schemes to avoid compromising the quality of procured goods or deterring foreign investors.

Tax policy: incentives should be carefully designed

All countries use tax incentives to attract investment. This has at times stimulated a detrimental “race to the bottom” among countries competing to attract the same investors without giving due attention to whether investment inflows proportionally increase as a result. There has been a dramatic increase in the number of tax incentives offered in sub-Saharan Africa: 69% of the countries offered tax holidays in 2005, compared to 45% in 19805. However, in many countries, the attribution of fiscal incentives has sparked intense internal debates. Turning to Asia, in the Philippines, a fiscal harmonization bill aiming to redress a complicated investment incentives system has been pending for over a decade6. This partly results from the realization that such schemes have jeopardised the fiscal revenues of several countries. Indeed, the foregone revenue from incentives could arguably have been used for much-needed financing of sustainable development. Moreover, in many developing countries, excessive discretion granted to the relevant decision makers and low transparency in the award of investment incentives blurs the picture for investors and revenue authorities alike and may create opportunities for corruption.

Asking an individual country to unilaterally and radically change its investment incentives scheme is a difficult sales pitch (a regional approach to avoiding “beggar thy neighbour” investment incentives could, however, be a good first step). At the same time, developing countries’ governments have much room for improvement in establishing reliable and centralized mechanisms for evaluating the costs and benefits of investment incentives. These mechanisms should focus on the appropriate duration of incentives, transparency in their management and their impact on national economic interests and on other countries. Such efforts are particularly important given that tax incentives are rarely the tipping factor behind an investment decision in a developing country. A large majority of investors covered by investor motivation surveys of the World Bank’s Investment Climate Advisory claim that in the majority of cases (for instance over 90% in Rwanda, Tanzania and Uganda), they would have invested even if incentives were not provided.

Creating fertile ground for infrastructure investment is a priority

Infrastructure has a strong impact on a country’s investment attractiveness. The extensiveness of the road network, the efficacy of the port system and the length of container wait times, for instance, have clear implications for the timely and cost-effective delivery of goods. Likewise, water infrastructure has important implications for agricultural production, health and sanitation. Reliable power supplies are also key. Addressing the growing infrastructure gap is a priority for many developing country governments and given their limits of public funds, private investment has an important role to play. This requires attractive market structures, including the levelling of the playing field between public and private providers of infrastructure services. It involves ensuring predictable pricing and competitive infrastructure markets through sound market regulation.

Governments can also help create more space for private investment in infrastructure by improving the governance of state-owned operators and limiting their monopoly powers. When inefficiently run, state-owned operators can adversely affect the quality of network management, deterring private investment. The regulatory framework for infrastructure investment needs to be predictable and be suited for the risky nature of long-term infrastructure projects. Private participation in infrastructure delivery (in particular through public-private partnerships), while being an attractive option for governments in principle, is still a relatively recent form of procurement in many countries. To limit risks for private investors, laws and regulations, as well as institutional roles and responsibilities, need to be clear and understood by all parties. Public sector capacity for project design and implementation is also indispensable to avoid fiscally unsustainable contracts and costly contract renegotiations.

A marathon without a finish line

Many developing countries can feel overwhelmed by the challenges they face in their efforts to improve the enabling environment for investment. These are coupled with long lists of reform proposals and recommendations from bilateral donors, aid agencies and international organizations. Yet, the success stories of the likes of Rwanda, Singapore and Costa Rica provide not only “best practices” but also inspiration for reform-oriented governments. In taking the necessary steps at home, governments can also tap the large pool of available technical resources that can help them along the seemingly endless road of investment climate reform. These include the OECD Policy Framework for Investment, which embodies the complexity of the investment climate into one comprehensive instrument, ready for use by any country on a self-assessment bases; UNCTAD’s Investment Policy Framework for Sustainable Development and its elaborations on investment treaties; and the World Bank’s vast array of investment climate reform programmes. These are all inspired by international good practice to ensure that the inputs into the sustainable development equation lead to the expected outcomes.

Written by

Mike Pfister is an economist specialized in international investment and development. He has worked for consulting groups, the German Government and the United Nations Conference on Trade and Development. He is currently a Senior Policy Advisor at the Organisation for Economic Co-operation and Development. He has significant experience in managing investment climate reform programmes, designing public policies and supporting their implementation, as well as restructuring investment promotion agencies and training investment policy officials in Asia, Africa and Latin America. Mike contributes to the Africa Policy Review in his personal capacity.