Executive Summary

The economies of the Greater Mekong subregion (GMS)¹ have collectively grown at one of the fastest rates in the world since the early 1990s as many of them started the transition from central planning to a market-based system and became more closely integrated with the region and the world. In the 10 years to 2004, gross domestic product (GDP) in the subregion grew at an average annual rate of over 6%,² in spite of a number of adverse shocks. These included the 1997 financial crisis, the slowdown in the global and regional economies in 2001, the onset of the severe acute respiratory syndrome (SARS) in 2003, and more recently, the ongoing threat from avian flu and the persistent rise in oil prices.

Average economic growth in the subregion remained strong at 7.9% in 2005, although it was lower than in the previous year, primarily reflecting slower growth in Thailand, the subregion's largest economy. Growth in most other economies continued its upward trend. Inflationary pressures have increased in some countries with the persistent rise in world oil prices and higher food prices. But inflation rates remain within single digits as monetary policy has become more restrictive and the fiscal stance has been stable. The current account reverted to a deficit in Thailand for the first time since the 1997 crisis, reflecting higher oil imports, subdued tourism revenues, and strong (import-intensive) investment growth. In Viet Nam, the deficit narrowed for the second year helped by higher revenues from oil exports. Over the past few years, trade has expanded rapidly and the share of trade within the GMS has increased relative to that with the rest of the world. Net capital inflows, with a significant contribution from foreign direct investment (FDI), were sufficient to finance the current account deficits and foreign exchange reserves remain at comfortable levels.

In this report, we discuss in some detail the significance of FDI especially in the three transitional economies in the GMS-Cambodia, Lao People's Democratic Republic (Lao PDR), and Viet Nam (CLV). Attracting FDI has been a key focus of market-oriented policy reforms in these countries. As transitional economies, these countries require substantial amounts of investment to transform their economies and meet the economic, social, and other developmental goals that they have set themselves. The levels of domestic savings in these countries are far from adequate to meet these investment requirements, as reflected in their current account deficits. Support from bilateral and multilateral development agencies in the form of grants, loans (both soft and market-based) and technical assistance have an important role to play in this process, but the magnitude of the development challenges that these countries face is so great that much more will be needed. Furthermore, external debt levels are already quite high especially in Cambodia and the Lao PDR, so borrowings alone cannot be relied upon to fill resource gaps. This is where FDI comes in.

FDI can provide the resources to increase investment beyond domestic savings levels without adding to the external debt burden. But it can do much more than this. FDI can bring with it firm-specific knowledge in the form of technology, managerial expertise, marketing knowhow, and other things such as these that cannot easily be leased or purchased on the market by the host country. Indeed this may well be the key advantage provided by FDI.

Combining the direct contribution to growth through investment with the various indirect spillover effects suggests that FDI has the potential to play an important catalytic role in countries in the process of transition from command to market economies.

The experience of all three countries confirms this. FDI has played an important role in promoting GDP growth, export expansion, and employment generation in the CLV countries. There is empirical evidence that FDI has contributed to productivity growth in Viet Nam, and a host of anecdotal evidence that it has done the same in Cambodia and in the Lao PDR.

In Cambodia, the rapid expansion of FDI-driven clothing exports has become a major source of employment and income for women, reducing poverty and helping narrow the urbanrural income gap. Recently, FDI has also begun expanding into other labor-intensive export industries, such as shoes, toys, and wood products, which is further contributing to employment generation.

In the Lao PDR, foreign investment in the hydroelectric power and mining sectors are boosting GDP growth and creating substantial employment opportunities in this landlocked country. Furthermore, through taxes, royalties and dividends, the citizens of the Lao PDR stand to be significant beneficiaries of such FDI projects, as long as these revenue streams are well managed. FDI is also behind the rapid increase in mining-related exports, and there appears to be significant untapped potential in this area.

FDI has played an important role in transforming the economy of Viet Nam. There is a substantial amount of evidence that highlights the role of FDI in driving growth in GDP, exports and employment, as well as positive spillover effects in the economy through enhanced productivity. As long as the investment climate remains open and receptive, Viet Nam has the potential to further diversify FDI inflows, shifting it from the light-manufacturing sector to assembly and related activities in the electronics industry. If this happens, Viet Nam looks well placed to emulate the developmental achievements of its more advanced ASEAN neighbors.

To a large extent, the role that FDI can play in assisting in the transformation of these countries is limited by inherent deficiencies in the investment environment-poor physical infrastructure, limited domestic capacity in the form of human capital and entrepreneurial skills, and weaknesses in legal, judicial, and administrative structures. Strengthening of the financial and banking sectors and addressing vulnerabilities in the corporate sector are also important in improving the investment climate in the CLV countries. To varying degrees, policy uncertainty and perceived political interference or instability has affected perceptions of risk and hindered investment inflows as well. These are long-term developmental challenges that the CLV countries need to address, and significant progress has been made since the reform process began around the mid-1980s. Much more remains to be done in the future, however, if these countries are to attract the amounts of FDI that their more advanced ASEAN neighbors had done in transforming and modernizing their economies.

In short, the most significant constraint on FDI flows to the CLV countries is the perceived risk associated with investing there. In such an environment, investors will require a higher minimum return on their investment to compensate for the higher level of perceived risk. This has implications not only for the volume of FDI flowing to these countries, but also the quality of FDI that they receive. The higher rates of return required usually results in a large share of investments that are short-term in nature. These investments are sometimes described as being "footloose"; firms operating "with their bags packed" in readiness to flee the scene as soon as wages begin to rise and tax incentives begin to expire. This can cause disruption to labor markets and result in other forms of adjustment costs in the domestic economy.

The longer-term investments tend to be made only under certain preconditions. First, the investments tend to focus on resource-based activities. The expected returns also need to be sufficiently high, which usually translates into the host countries receiving a lower share of direct rents (royalties, taxes, dividends, etc.) that they would otherwise be able to negotiate. Second, the involvement of a third party, in the form of an honest broker, may be required in such projects so that they can be successfully concluded. Often this role is played by a multilateral development agency that can provide various forms of implicit and explicit guarantees. When the involvement of such a third party is either infeasible or unsolicited, then foreign investors may try to protect their investments through ad-hoc arrangements with local officials and partners. Corruption in this instance occurs not as a means to bypass government regulations, as is commonly the case, but rather to substitute for a lack of them. Such rent seeking activities impose costs on the domestic economy and distort the local investment climate. Most rent seeking activities also run counter to national interests.

There are a number of other less challenging and more immediate policy issues that can be addressed in order to improve the investment climate in these countries. These are policy changes that could be introduced almost immediately if the political will to do so exists. The first of these relate to investment incentives. There is a need to increase neutrality and reduce distortions that currently exist in the structure of investment incentives in these countries. Policies that encourage investments in a discriminatory manner, for example based on export requirements or by sector, distort prices and decision making and result in less than optimal outcomes that are welfare-reducing on the whole. Furthermore, a harmonized reduction in incentives offered, perhaps within the GMS or ASEAN framework, could allow governments to use the revenue savings to improve the overall fiscal environment, as well as the physical and social infrastructure of the country. If they can do this, then it could be more effective in attracting FDI than the incentives themselves.

There is also a need to ensure that so-called "one-stop shops" for foreign investors operate as such and are effective in practice. In the Lao PDR for instance, the Foreign Investment Management Committee is supposed to play this role but because the process has not been integrated and coordinated across government departments, the Committee has become a "one-more-stop shop," and this serves to delay applications to the point where a significant amount of FDI is being denied the country.

Addressing these short-term policy and procedural issues is likely to produce immediate results in terms of the volume of FDI. Addressing the longer-term challenges particularly in relation to infrastructure, human capital, and legal, judicial, and administrative structures will affect not only the volume, but also the quality and industrial composition of FDI. Longer-term investments in a more diversified array of sectors can be expected, as well as greater productivity and other spillovers to the domestic economy. Through the direct involvement of multilateral development agencies such as ADB and the World Bank or through public-private partnerships that they facilitate, FDI may also be able to play an important role in addressing these challenges. This is already happening today in the region, with road, energy, and telecommunications infrastructure through the GMS program of ADB, for instance, but the role that FDI can play in this process has yet to be fully tapped.

The views expressed in this paper are the views of the author/s and do not necessarily reflect the views or policies of the Asian Development Bank Institute nor the Asian Development Bank. Names of countries or economies mentioned are chosen by the author/s, in the exercise of his/her/their academic freedom, and the Institute is in no way responsible for such usage.

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1. Hong, Sung Ho
   (posted 05 November 2006 / 07:05:25 PM)
   
   I think that the country needs to be in the position where they can control the FDI, in other words, they have to attract the foreign countries' investors in many area of industries.
   
   Having a FDI on what the investors think they can have most profit. It may not be the same industry that the country who is getting a FDI wants to improve on.
   
   In the long run, in order to trigger the spillover or synergy effect, the country needs to have a specific and long term economic growth plan so that they know what industry needs FDI. I think that a country that is getting a FDI needs to diversify to attract foreign investors and more importantly they (government) needs to have a long term economic plans.