Foreign Direct Investment in the Transition Economies

Attracting foreign direct investment (FDI) has been a key focus of market-oriented policy reforms in the three transitional economies in the GMS-Cambodia, Lao PDR, and Viet Nam (CLV). The thrust to encourage FDI is rooted in the belief that it can play a catalytic role in supporting the process of economic transition in these countries, and act as a conduit for revitalizing the private sector. Although much has been written on the role and impacts of FDI in Thailand and the PRC, there is a dearth of systematic comparative analysis of FDI flows to these transitional countries and their developmental impacts.

For this reason, we focus on the CLV countries.³ For completeness, we summarize later in Box 3 and Box 4, respectively, the PRC's FDI experience, focusing on what impact it has had on FDI flows in the broader region, and Thailand's experience with an emphasis on the postcrisis period. The analysis of the FDI experience in the CLV countries is conducted by: (i) surveying the evolution of FDI policy in these countries in the context of overall policy reforms and the current state of the investment climate; (ii) examining the experience with attracting FDI from a comparative regional and global perspective, with a view to informing the debate on how to reform the policy regimes; and (iii) assessing the development impacts of FDI in the economy, focusing on the impact on GDP and its domestic components, employment, exports and productivity growth.

The analysis is organized in four sections. Section A provides an analytical account of the nature, developmental implications, and typology of FDI in order to place the ensuing discussion in context. Section B reviews the FDI policy and investment environment in the three countries with emphasis on key policy shifts and similarities and difference in the current policy regimes. Section C examines trends and patterns of FDI, focusing in turn on trends in total inflows against the backdrop of regional and global trends, source-country and sectoral/industry composition, and emerging patterns of intra-regional flows. Section D examines the developmental impacts of FDI. Emphasis is placed on the roles that the reform agenda and policy changes have had in determining outcomes.

Analytical Context

1. What is FDI?

Foreign direct investment originates from the decision of a resident entity to obtain a lasting interest in an enterprise in another country. The entity is usually a multinational enterprise (MNE) and the investment is generally associated with relocating part of its production activities to the host country. In other words, FDI is a flow of long-term capital based on long-term profit considerations and is associated with a significant degree of influence or control by the investor in the management of the enterprise. It is this element of "influence and control" that distinguishes FDI from portfolio investment and other forms of international capital flows.

2. What can FDI Offer?

The most obvious contribution of FDI and other forms of international private capital flows to the capital receiving country is to increase domestic investment beyond the level permitted by domestic savings. This in turn enables the country to grow with less sacrifice to current consumption, or without increasing its stock of external debt. FDI, however, is unique among capital flows because its role is not limited to adding to investment in the host country.

FDI can bring with it firm-specific knowledge in the form of technology, managerial expertise, marketing know-how, and other things such as these that cannot easily be leased or purchased on the market by the host country. Affiliates of MNEs, as part of the parent company's global network, often have marketing channels in place, possess experience and expertise in the many complex facets of product development, and are well placed to take advantage of inter-country differences in costs of production. When foreign firms employ domestic labor, various forms of formal and informal training that is generally unavailable in local firms is usually provided. On these grounds, FDI enables managers and workers in the host country to acquire and spread knowledge and technology faster than would otherwise be possible. It may also allow local entrepreneurs to learn about export markets and stimulate competition with local firms.

These various favorable indirect effects arising from the presence of foreign-affiliated firms in an economy are generally referred to as "spillover effects" of FDI. Indeed these spillover effects may well be the key advantage provided by FDI. Ideas can be as important as physical inputs, and an economy can grow just because new ideas beget more new ideas, as postulated by the endogenous growth theory (Romer 1992). This aspect of the role of FDI is both more subtle and substantive because knowledge spillover is an economy-wide phenomenon, and is by no means limited to the particular industry in which the foreign firm is located. The introduction of new ideas of efficient management, inventory systems, worker training, or incentive systems may result in application in other industries as well (Athukorala and Menon 1995).

However, the developmental impact of FDI tends to vary across countries depending on a number of factors. The extent of spillover effects depends on the nature of the domestic policy regime and various resource-endowment related factors such as domestic capacity in the form of human capital and entrepreneurial skills. In relation to the policy regime, a country with an outward-oriented approach has the potential to reap greater benefits from FDI than a country whose policy regime is biased in favor of import substituting production. This is because, in contrast to an import-substitution program, an export-oriented regime tends to encourage FDI in activities where the host country enjoys natural comparative advantage in international production. As regards domestic resource endowment, a country at an advanced stage of human capital and entrepreneurial development is better placed to reap technological spillovers from the presence of foreign-affiliated companies than a country that is poor in terms of this condition.

3. Determinants of FDI

A country's attractiveness as a site for foreign investment is determined by a combination of its comparative advantage in international production and the domestic investment climate. The term "investment climate" covers the foreign investment regime (rules governing foreign investment and specific incentives for investors such as tax holidays and repatriation of profits) and the general investment environment, which refers to a variety of factors including political stability, macroeconomic environment, adequacy of social and physical infrastructure, level of institutional development, and the attitude of host countries towards foreign enterprise participation.

The CLV countries are rich in terms of their endowments of natural resources, and possess a competitive edge when it comes to the cost of labor. If there is a constraint on attracting FDI, then it would have more to do with the domestic investment climate in these countries. In terms of the two components of the domestic investment climate, it would appear that it is the general investment environment rather than the foreign investment regime that plays the more limiting role. The general investment environment is compromised by the inherent deficiencies that these countries face, such as poor physical infrastructure, limited domestic capacity in the form of human capital and entrepreneurial skills, and underdeveloped legal, judicial, and administrative structures. Weaknesses in the financial and banking sectors and vulnerabilities in the corporate sector add to the perception of high risk. To varying degrees, policy uncertainty and perceived political interference or instability has affected perceptions of risk and hindered investment inflows as well.

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 levels 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" in that the sunk cost involved is low and firms are able to liquidate their investments easily and quickly, should the need arise. This can cause significant 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.) than they would otherwise be able to negotiate. Second, the involvement of a third party, in the form of an honest broker, may be required before the project 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 can occur not as a means to bypass government regulations, but rather to substitute for a lack of them. Such arrangements provide opportunities for rent seeking activities that can impose costs on the domestic economy and distort the local investment climate. Most rent seeking activities also run counter to national interests.⁴

The effectiveness of the foreign investment regime in attracting FDI is critically linked to the general investment climate. The literature on the effectiveness of incentives suggests that tax concessions and other profit-related incentives are relevant only if the general investment climate is conducive for profit making. In other words, incentives may matter only if the overall political, financial and macroeconomic environment is conducive for investment. Even if the overall investment climate is attractive, incentives offered by a given country can be quickly matched by other countries competing for the FDI dollar. Indeed, this process of trying to match incentives-or tax competition-offered by competitors can lead to an inferior, non-cooperative outcome. This basic problem is exemplified by Baldwin (1994, p.139) using the so-called passing parade parable:

"Imagine that a crowd gathers to watch a parade. As the parade passes, people in the front stand on their toes to see better, thus forcing all those behind them to also stand on their toes. In the end, most see no better than before, but all have to stand on their toes".

On this basis, there may be a case to be made for harmonizing tax incentives across countries that tend to compete for similar types of FDI (Box 1 [ PDF 93.1KB | 1 pages ]). Although investment incentives may indeed be too generous, in that the costs outweigh the benefits, in the CLV countries, there are other reasons for having them. Investment incentives may, for instance, have an "image building" role to play; a country widely perceived as being unfriendly to foreign investors may use generous incentives as a tool to regain an image that is welcoming to FDI. Specific, well-targeted incentives can be a useful instrument in winning so-called investment tournaments when it comes to attracting large investment projects. Finally, incentives offered to FDI in countries where corruption is present and the administrative capacity to collect domestic taxes is weak are often perceived as playing a role in leveling the playing field. These incentives can work to enable legitimate business to compete more fairly with illegitimate ones.

4. Different Types of FDI

Assuming a favorable investment environment, what are the typological characteristics that determine a country's comparative advantage in international production? In answering this question, it is important to emphasize that FDI is not a homogeneous phenomenon, but a complicated and finely differentiated instrument in the globalization of production. For the purpose of discussing factors impacting on foreign firms' decision to locate production in a given country, it is important to distinguish between three categories of MNE affiliates in terms of their operations.⁵

These are: (i) market-seeking investors ¨C producers largely engaged in serving the domestic market; (ii) resource-seeking investors ¨C firms involved in extraction and processing of natural resources, usually for export but sometimes for the domestic market as well; and (iii) efficiency-seeking investors ¨C those engaged in production for the global market. In the discussion that follows, we group resource-seeking investment with efficiency-seeking investment because, in the context of the transitional economies of the Mekong region, resource-seeking investment is almost completely export-oriented.

1. Market-seeking Investment
   
   When it comes to market-seeking investment in developing countries, the forces explaining the location decisions of MNEs are about the same as those explaining their presence in industrialized countries. The location decision depends primarily on the prevalence of production opportunities in the host country for meeting domestic demand. Given minimum efficient scale requirements and generally small domestic markets in many developing countries, a major (if not the key) determinant of this type of FDI relates to restrictions imposed on international trade. When market-seeking FDI is driven predominantly by barriers to trade, it is described as "tariff jumping" FDI. The so-called "life-cycle" investors who expand their production networks globally on scale- economy and efficiency considerations do not generally find low-income countries an attractive investment location under free-trade conditions.
   
   When the country concerned is a member of a free trade area (FTA), then the tariffjumping motive needs to be considered in the context of the regional rather than the domestic market. In other words, there is a market enlargement effect that now combines the domestic market of the country concerned with the markets of the rest of the countries in the FTA. Furthermore, the attractiveness of the country within the FTA for tariff-jumping investment depends on the magnitude of the "margin of preference," the difference between the preference tariff and the tariff applicable to trade with third parties. Differences in tariff rates between members may be important for procuring low-cost imported inputs, which could influence the location of investment in relatively low tariff countries within the FTA from third countries as well as from high tariff countries within the FTA. This influence would be magnified if there are significant differences among member countries in terms of non-tariff barriers to third country trade (Athukorala and Menon 1997).
   
   In theory, under certain circumstances, MNE affiliates originally set up to serve local or regional FTA markets could well develop competitive advantage over time and penetrate markets in third countries without government support. But in the real world such cases are rare and limited predominantly, if not solely, to middle-income and upper-middle-income developing countries with sizeable domestic markets.
2. Efficiency-seeking Investment
   
   The role of MNEs in efficiency-seeking investment is distinctively a developing-country phenomenon. In determining the attractiveness of a host country in drawing in export-oriented FDI, it is important to distinguish between two different categories of export-oriented production: labor-intensive final consumer goods (clothing, footwear, toys, sports goods, etc.); and assembly processes within vertically integrated global production systems (electronics, automotive products, etc.).
   
   For the typical developing economy, labor-intensive consumer goods are generally considered the natural starting point in the process of export-led industrialization. However, the role of FDI in this area remains a controversial issue. In the spectacular export take-off of the East Asian newly industrialized economies (NIEs) in the 1960s, the key role was played by indigenous firms with the help of marketing services provided by foreign buyers-the Japanese trading houses and the large retail buying groups in developed countries.

5. Lessons from the East Asian Experience

Can the East Asian NIE experience of local-entrepreneur dominance in exports be replicated in the so-called "latecomer" countries of developing Asia today? This appears unlikely for at least two reasons. First, perhaps the most important factor behind the East Asian experience was the unique entrepreneurial background of these countries. Hong Kong, China, and Taipei,China and to some extent Singapore started with a stock of entrepreneurial and commercial talents inherited from the pre-revolution industrialization period in the PRC; Hong Kong, China; and Singapore also had well-established international contacts based upon entrepot trade that involved exporting manufactured goods to begin with. Therefore, there was not such a large difference between domestic and foreign firms in these countries with regard to knowledge of and access to production technologies and market channels. However, the initial level of entrepreneurial maturation in latecomer countries is generally not comparable to that of the NIEs. In many of these countries, the import-substitution growth strategy pursued indiscriminately over a long period of time has thwarted the development of local entrepreneurship. Domestic firms are generally weakly oriented toward, and have limited knowledge of, highly competitive export markets.

Second, from around the mid-1980s, export-oriented firms from the East Asian NIEs have begun to play an increasingly important role as direct investors in the labor-intensive export industries of latecomer countries. Two main factors account for this trend: the erosion of international competitiveness of labor-intensive export products from their home countries as a result of rising real wages and exchange rates; and the imposition and gradual tightening of quantitative import restrictions under the Multifibre Arrangement (MFA) by industrialized countries on certain labor-intensive exports (mostly textiles, garments, and footwear).

These investors from East Asia possess a critical advantage over many other investors. Unlike MNEs from developed countries, they are usually familiar with and are able to more easily adapt to the relatively difficult business conditions in latecomer countries. In other words, they are better suited to dealing with prevailing constraints such as poor infrastructure, bureaucratic red tape, and unpredictable policy settings, among other things. Given that NIE firms are equipped with considerable specialized knowledge of small scale and labor-intensive production processes in the manufacture of standardized products, they have a powerful competitive advantage over both local firms and MNEs from the industrialized world in the difficult local business environments in the latecomer countries. There are indications that, consistent with rapid structural transformations that are taking place in the NIEs, the intermediary role that these "new" investors are playing in linking latecomers to world markets may become increasingly important in years to come.

Production of labor-intensive components and their assembly within vertically integrated international industries ("international product fragmentation" or "outsourcing") in developing countries has been an important feature of the international division of labor since about the late 1960s. The process was started by US electronics MNEs in response to domestic real-wage increases and rising import competition from low cost sources. The transfer abroad of component assembly operations now occurs in many industries where the technology of production permits the separation of labor-intensive components from other stages of production. Assembly operations in the electronics industry (in particular assembly of semiconductor devices, hard disk drives, etc.) are still by far the most important. The other industries with significant assembly operations located in developing countries are electrical appliances, automobile parts, electrical machinery and optical products, musical equipment, watches, and cameras. In general, industries that have the capacity to break up the production process to minimize the transport cost involved are more likely to move to peripheral countries than other heavy industries.

The expansion of overseas assembly operations as an important facet of international production has been hastened by two mutually reinforcing developments over the past few decades. First, rapid advancements in production technology have enabled the industry to slice up the value chain into finer, "portable", components. Second, technological innovations in communication and transportation have shrunk the distance that once separated the world's nations, and improved speed, efficiency, and economy of coordinating geographically dispersed production process. There is evidence emerging that global assembly exports are growing much faster than total manufactured exports (Feenstra 1998, Athukorala 2006).

While the availability of cheap and trainable labor is a prerequisite for attracting FDI into both these product areas, it is not the only determining factor. The availability of a wider array of complementary inputs, including operator, technical and managerial skills, availability of domestic inputs, and high-quality infrastructure are critical in making assembly operations efficient by world standards. Also, given the heavy initial fixed costs involved, MNEs appear hesitant to establish assembly plants in countries without a record of policy continuity and political stability. All of these reasons may account for the fact that only a limited number of developing countries-mostly the high-performing East Asian countries and more recently some transition economies in Eastern Europe-have been able to attract FDI in assembly operations.

Based on the above typology of FDI, what are the opportunities available for Cambodia, Lao PDR, and Viet Nam in attracting FDI? The ability of Cambodia and the Lao PDR to attract market-seeking, import-substituting FDI is limited by the relatively small size of domestic markets. Given its larger domestic market, Viet Nam may be better placed to attract such investment but there are other reasons why this is unlikely to happen to any significant degree. Enticing import-substituting FDI by raising tariff barriers is unlikely to work when borders are so porous, and furthermore any such move would run counter to its overall development policy geared toward greater openness and outward-orientation. Even if we consider the larger regional market covered by the ASEAN Free Trade Area (AFTA), the fact that both mostfavored nation (MFN) and preferential tariffs in the CLV countries are higher than in the original ASEAN members (so that the "margin of preference" in the former would not be necessarily higher) would limit opportunities to attract tariff-jumping FDI (ADB 2004).

All three countries, the Lao PDR in particular, have substantial untapped potential in attracting resource-seeking investors. The extent to which such investment materializes appears to depend mainly on political-economy considerations impinging on natural resource management policy.

In the area of export-oriented FDI, the attractiveness of the Lao PDR to foreign investors has been limited mainly because of high transport costs arising from its landlocked geography and opportunities appear to be limited to labor-intensive consumer goods production. In recent years, this constraint has been alleviated with the development of cross-border transport, for example within the framework of the GMS Economic Cooperation program. Furthermore, a country can adapt to high transport costs and other trading disadvantages arising from its being landlocked and distance from markets by specializing in "low weight per unit value" products, provided, of course, the overall economic environment is conducive for such a market response.

As a low-wage country located in proximity to rapidly growing East Asian economies, Cambodia has significant potential for attracting FDI in standard labor-intensive manufacturing. But, in terms of key criteria such as political stability, institutional quality and supply of skilled labor, it has a long way to go in becoming attractive as a location for assembly activities in vertically integrated global industries.

B. Investment Climate

As noted earlier, the term "investment climate" encompasses both the foreign investment regime and the general investment environment. In this section, we survey the evolution of FDI regimes under market-oriented reforms followed by a comparative assessment of the current state of the overall investment climate.

1. FDI Policy

The opening up of Cambodia, Lao PDR, and Viet Nam to FDI occurred almost concurrently in the late 1980s. Since then the FDI regimes of the three countries have gone through several changes as an integral part of the ongoing policy of transition toward marketoriented economies. In general, FDI policy regimes have become more liberal and the sectors open to foreign investment have expanded over the past 2 decades. Nevertheless, much remains to be done in order to deepen the reforms and improve the business environment in order to make the economies more attractive to foreign investors and to enhance gains to the national economy.

1. Cambodia
   
   The Kampuchea People's Revolutionary Party (KPRP) government embarked on a market-oriented reform process in 1985. As part of these reforms, the government promulgated a liberal foreign investment code in July 1989 and a National Investment Council was set up in 1991 with the task of reviewing all foreign investment applications. The outcome of these reforms was somewhat lackluster however, and perhaps unsurprising given the continuing warfare between KPRP forces and the Khmer Rouge. As an outcome of the UN-led peace process, elections were held in July 1993 and a multi-party democratic government was established in September 1993.
   
   The new government set up the Cambodian Investment Board (CIB) under the Council for Development of Cambodia (CDC) to be the "one stop" service organization responsible for approving foreign investment applications. The new Laws and Regulations on Investment in the Kingdom of Cambodia passed by the National Assembly on 4 August 1994 set out rules and regulations governing FDI and offered an incentive package to foreign investors that was very generous compared to those in other countries in the region. The new incentives included a tax holiday of up to 8 years and a concessionary corporate tax rate of about 9% after that (as against a standard rate of 20%). Total freedom to repatriate profits or proceeds of investment without paying withholding tax was granted. Reinvested profits were exempt from corporate tax. Investors were also provided with guarantee against nationalization and against price control, and relatively unhindered access to foreign exchange. The business turnover tax was abolished in 2000.
   
   The foreign investment regime in Cambodia underwent an overhaul in 2003. The revised Law on Investment came into force on 27 September 2005, and represented a major attempt to equalize incentives for foreign and local investors, to achieve greater transparency in incentives provided, and to minimize distortions and delays arising from policy maker discretion. The 8- year blanket tax holiday for foreign investors was replaced with a "3 years + n" tax holiday for all qualifying new investors (foreign and local), under which "n" is conditional on annual certification of compliance as part of the general tax administration of the country rather than at the discretion of the investment monitoring authority (CIB). When the tax holiday expires, all investment projects are subject to the standard corporate tax rate (currently 20%) and all previously approved and operational projects currently subject to the 9% concessionary corporate tax are to be brought under the standard corporate tax rate within the next 5 years. In place of the provision of tax-free reinvestment of profits, a generous accelerated depreciation allowance was introduced under the general tax law for all qualified investors, irrespective of source of finance. Profit that is repatriated is now subject to a 1% withholding tax. As part of the new reforms, a fast track procedure has been introduced with the aim of approving investment applications within a 14-day period under the "one-stop service" at CIB. Seven working groups, which involve both private and public sector participation, have been set up in key sectors to work in collaboration with CIB to facilitate speedy investment approval, monitoring, and promotion. An investor forum, headed by the Prime Minister, is held twice a year as part of the new investment regime.
   
   In December 2005, a sub-decree was passed to provide the legal framework for setting up special economic zones (SEZs), which may include general industrial zones and/or export processing zones (EPZs). As of March 2006, proposals for setting up SEZs had been approved with one (Bavet Zone near the Viet Nam border) already accepting investors.
2. Lao PDR
   
   The process of transition to a market-oriented economy in the Lao PDR began in 1986 with the implementation of the New Economic Mechanism, a major program of economic reforms. As part of the reform program a Foreign Investment Code was passed in July 1988 and the Foreign Investment Management Committee (FIMC) was set up under the direct purview of the Prime Minister to act as the apex agency that approves monitors and promotes FDI. At the initial stage, the prime objective of the FDI policy in the Lao PDR was to engage foreign investor participation in restructuring of state-owned enterprises (SOEs). The Investment Code was supplanted by the Law on Promotion and Management of Foreign Investment in July 1994 which was again substantially revised in October 2004.
   
   Foreign investment is permitted in all business sectors, with 100% ownership allowed in most sectors, except in mining and energy projects in which the Government contributes to share capital or retains the right to buy a pre-agreed share of equity. In joint ventures, foreign equity participation is required to be at least 30% of total invested capital.
   
   The structure of tax incentives for foreign investors has been designed to take into account the country's geography (mountainous terrain) and uneven quality of infrastructure in different parts of the country. Investment projects in areas where there is no economic infrastructure to facilitate investment (Zone 1), are eligible for a 7-year tax holiday and 10% concessionary tax rate (compared to the standard corporate income tax rate of 35%) thereafter. Investment projects in areas with a certain level of economic infrastructure (Zone 2) are eligible for a 5-year tax holiday, a concessionary tax rate of 5.5% for the following 3 years and a 15% rate thereafter. Investment projects in areas regarded as having good infrastructure are entitled to a 2-year tax holiday followed by half of the standard corporate tax rate for 2 years and the full corporate tax rate thereafter.
   
   In the forestry sector, the Government intends to establish a financially viable and selfsustaining Lao Plantation Authority, which will spearhead the efficient and sustainable development of the plantation subsector in the country. A number of foreign companies in the pulp and paper industry have invested or are in the process of investing in plantations in the country.⁶
   
   For projects in mining and energy sectors (which by their very nature tend to be located in remote areas), specific taxation arrangements are negotiated on a case-by-case basis. For instance, the incentive package offered to the Sepon Gold and Copper mining project7 includes a 2-year tax holiday initially, then 50% reduction in the corporate tax rate for 2 years, which then reduces to 33% for the 2 years following that. A 4.5% royalty on mineral production applies throughout the period of commercial operation. A 5-year tax holiday followed by 10% and 15% corporate profit tax during the next 5-year periods is applicable to the Nam Theun 2 hydroelectricity project, a $1.3 billion trans-basin diversion power plant in the central region of the country implemented by an international investment consortium led by Electricite du France.
   
   The FIMC aspires to be a "one-stop shop" for foreign investors with the aim of approving investment applications within 60 working days. However, the Lao investment law lacks supporting implementing regulations and some of its elements are not compatible with various other laws, including the domestic investment law and some other sector-specific legislation. Thus, in practice FIMC must consult other government bodies and agencies on applications for large investment projects. There is also likely to be some input from the Lao Government on investment proposals pertaining to sensitive or strategic sectors. As a result, the 60-day deadline for approving FDI applications is not always observed. After receiving an investment license, the foreign investor must also obtain other licenses and permits to operate, for which FIMC may only provide assistance.
3. Viet Nam
   
   The opening of the economy to FDI was part of Viet Nam's "renovation" (doi moi) reforms initiated in 1986. The Vietnamese National Assembly passed the first Law on FDI on 29 December 1987. The law specified three modes of foreign investor participation, namely (i) business cooperation contracts (BCCs), (ii) joint-ventures, and (iii) fully foreign owned ventures. Foreign participation in the fields of oil exploration and communications was strictly limited to BCCs. In some sectors such as transportation, port construction, airport terminals, forestry plantation, tourism, cultural activities, and production of explosives, joint-ventures with domestic state-owned enterprises (SOEs) was specified as the mode of foreign entry. Fully foreign-owned ventures were to be allowed only under special circumstances relating primarily to policy priorities for domestic industrial development.
   
   The Government provided constitutional guarantees against nationalization of foreign affiliates and the revocation of ownership rights of enterprises. The incentives offered to foreign investors included exemption from corporate tax for a period of 2 years, commencing from the first profit-making year, followed by a preferential corporate tax rate of between 15% and 25% in priority sectors (as against the standard rate of 32%). Foreign investors were permitted to repatriate after tax earnings subject to a 10% withholding tax. Overseas remittance of payments for the provision of technology services and repayment of principal and interest on loans were freely allowed. The specific emphasis on joint ventures with SOEs as the prime mode of foreign entry reflected the Government's decision to use FDI as a vehicle for industrial transition while ensuring state dominance in the economy. However, in 1990, the foreign investment law was amended to permit economic organizations in the private sector to engage in joint ventures with foreign partners. In 1991, legislation was passed allowing EPZs to be set up, and generous incentives were provided to firms involved in the production of goods for export (Box 2 [ PDF 92.9KB | 1 pages ]).
   
   Procedures for the approval of investment projects were streamlined and fresh investment incentives were granted under a new Law on Foreign Investment enacted in 1996. Under this Law, authority to issue licenses for projects, up to specified sizes, was delegated to local governments. For investments in so-called priority sectors, the tax holiday period was extended to 8 years, after which a rate of 10% applied. A three¨Ctier withholding tax of 5%, 7%, and 10%, based on the "priority status" of the investment, was introduced in place of the original flat rate of 10%.
   
   These revisions to the foreign investment law led to a massive influx of FDI, which in turn fuelled a growing sense of resentment within Viet Nam. This resentment resulted in a number of measures that raised serious concerns in the international investment community about Viet Nam¡¯s commitment to promote itself as a new investment center. These included a proposal to establish liaison offices of the Government in all foreign ventures, the doubling of commercial and residential rents for foreign enterprises and expatriate staff, the imposition of a maximum time limit of 3 years on work permits issued to foreigners employed in FDI projects, and restrictions on foreign participation in labor-intensive industries. There is also some evidence that suggests that the foreign investment approval process was skewed in favor of key high-tech industries such as metallurgy, basic chemicals, machinery, pharmaceuticals, fertilizer, electronics, and motor vehicles. Notwithstanding the new legislation that permitted domestic private enterprises to enter into joint ventures with foreign firms, joint ventures with SOEs continued to receive powerful support in senior policy circles as the prime mode of FDI entry.
   
   All of this changed after the Asian financial crisis. Policy reforms following the economic downturn during 1997¨C1999 placed renewed emphasis on FDI promotion. Under an amendment to the FDI law on 9 June 2000, foreign invested enterprises (FIEs) and parties to BCCs were given freedom to change the mode of investment, and to split, merge and consolidate enterprises. Recently there have been several cases of joint ventures being converted into 100% owned FIEs. The three-tier withholding tax on profit transfers was reduced to 3%, 5% and 7%. The approval procedure for new investment proposals was streamlined, with automatic registration of export-oriented FIEs. Foreign investors were allowed to implement socalled "less sensitive" projects (that is, those deemed not to have any implications on national defense, cultural, and historical heritage or the natural environment) without licensing scrutiny of the Ministry of Planning, provided they are export oriented. In April 2003, 100% foreign-owned companies were allowed to become shareholding companies (that is, they were allowed to establish joint ventures). The implementation of a new Enterprise Law in 2000 permitting greater participation of domestic private enterprises in the economy also significantly contributed to improving investor confidence in the reform process. Finally, the Unified Enterprise Law and Common Investment Law passed in December 2005 aim to boost private investment by further reducing administrative barriers to business development and expansion, and to facilitate WTO membership.
   
   The FDI regime in Viet Nam has certainly become more investor friendly since about 2000. However, the investment regime remains less open to FDI compared to its more advanced Southeast Asian neighbors. For instance, there is a 30% minimum requirement on the foreign partner¡¯s contribution to the registered equity capital of a joint venture. BCCs remain the only permitted mode of foreign entry into oil exploration and telecommunication sectors. Only joint ventures or BCCs are allowed in air transportation and airport construction, industrial explosive production, forestry, culture, and tourism. Viet Nam¡¯s current business legislation is also not conducive to cross-border mergers and acquisitions (M&As). Foreign investors are permitted to acquire only up to 49% of a local (listed or unlisted) company, if it operates within one of the 35 approved business sectors. Local companies may issue shares to foreign investors only in these sectors, and approval from the Prime Minister¡¯s office is required. This restrictive approach to M&As is a major constraint on the expansion of FDI inflows to Viet Nam because cross-border M&A activity has been increasing as a share of global FDI flows in recent years.
   
   There are export performance requirements (that is, the need to export certain percentage of output in order to become eligible for investment incentives) in some industries. In industries such as dairy production and dairy processing, sugar and sugar cane, natural oil, and wood processing, FDI projects must include investment in associated processing activities. Firms that export over 30% of production and/or use up to 30% of local materials in the production process are eligible for concessionary duties on imported inputs. There are stringent local content requirements in automotive, electronics, and engineering industries: import tariffs are set in these industries according to local content ratios with the aim of promoting backward input linkages.
   
   In sum, Viet Nam has progressed a long way in terms of opening up its markets to FDI, especially in the aftermath of the Asian financial crisis. There is, however, still plenty of room for reform. If Viet Nam is to try and emulate its more advanced ASEAN neighbors that have successfully used FDI as an engine of growth, then a new wave of wide-ranging reforms will need to be undertaken with some urgency. The commitments under the ASEAN Investment Area (AIA), the Bilateral Trade Agreement with the US and the impending accession to the WTO could prove to be a catalyst in this respect.
   
   The key elements of FDI policies in Cambodia, Lao PDR, and Viet Nam are summarized in Table 1. In an overall comparison, the Cambodian policy regime is more liberal compared to that of the other two countries. Following the recent (2003) reforms, Cambodia has also achieved greater neutrality in investment incentives offered to foreign and local investors. In the Lao PDR and Viet Nam, the incentive regimes favor foreign investors over domestic investors in various specific, and often distortionary, ways. Moreover, FDI regimes in these two countries are characterized by a greater degree of selectivity.

2. Business Environment

After a decade and a half of policy reforms, how do international investors rate Cambodia, Lao PDR, and Viet Nam as potential investment sites? Have recent attempts to reform the FDI regimes and streamline the investment approval procedures brought about anticipated results? What are the key concerns of investors about the investment environment? There is no straightforward way of providing answers to these fundamental questions, but the information summarized in Tables 2 through 4 does provide some useful insights that should guide future reforms.

The World Economic Forum in its World Competitiveness Report ranks countries in terms of two composite indices measuring long-term growth prospects and business competitiveness. In 2005, Cambodia ranked 112th in terms of growth competitiveness and 104th in terms of business competitiveness out of 117 countries covered (Table 2; the Lao PDR is not covered in World Economic Forum rankings). Viet Nam was better placed in both rankings compared to Cambodia but it ranked below all other high growth countries in the region. The Economic Freedom Index (Table 3), which measures overall quality of the institutional and policy frameworks for private-sector growth comes up with a slightly different ranking. On this index, Cambodia performs better than Lao PDR and Viet Nam and its relative performance has improved over time (68th among 157 countries in 2005, compared to 108th among 161 countries in 1997).

The Doing business database of the World Bank Group ranks countries in terms of 10 key indicators of business environment and provides detailed information on the characteristics of individual countries relating to each indicator. Information from this database for the three countries together with the PRC and Thailand is summarized in Table 4. There are significant differences among the three countries in their rankings based on these criteria, but overall they rank poorly among the countries in the region (and globally). They perform particularly poorly in terms of labor market flexibility (hiring and firing), credit availability, registering property, investor protection, ease of trading across borders, and enforcing contracts. There is clear evidence that recent attempts to streamline and expedite investment approval procedures have yet to deliver expected results. To some extent, this may be a reflection of issues relating to implementation policy may have changed, but practices may have not. In all three countries, the complex bureaucratic requirements and procedures for getting a project approved and implemented appear to remain a major obstacle to investors.

C. FDI: Trends and Patterns

Data on gross FDI inflows to Cambodia, Lao PDR, and Viet Nam over the post-reform era are depicted in Figure 7 [ PDF 87.1KB | 1 pages ]. Table 5 shows relative performance of these countries as hosts to FDI in a comparative regional and global context.

The response of foreign investors to economic opening of the three countries was swift nd notable, but the investment boom was rather short-lived. Annual gross FDI inflows to Vie Nam surged from negligible levels in the first half of the 1980s to an annual average of $780 million in 1990¨C1995 and to $2.6 billion in 1997. FDI amounted to over a third of gross domestic capital formation (GDCF) and nearly 10% of GDP during 1995¨C1997. There was a precipitous fall in FDI that started in 1997, and bottomed out at $1.2 billion in 2002. Since then there has been a notable recovery, reaching $1.6 billion in 2004. Official investment approval records suggest that this trend should continue well beyond 2005; total registered investment in realized FDI projects increased persistently from $19 billion in 2001 to $29 billion in 2005. Annual FDI inflows to the Lao PDR increased from $23 million (8% of GDCF, or 1.7% of GDP) in 1990¨C 1994 to $128 million (23.6% of GDCF, 6.8% of GDP) in 1996, before declining thereafter to reach a low of $17 million (3.2% of GDCF, 0.7% of GDP) in 2004⁸. In Cambodia, inflows of FDI reached a peak of $294 million (72.4% of GDCF, 8.7% of GDP) in 1997. As in the Lao PDR, the ensuing years have seen a general decline but with a greater degree of variability.

FDI approvals data for both countries point to a likely reversal in the declining trend from 2004 onwards. In the Lao PDR, a number of large investment projects in the mining and hydroelectricity sectors are currently being implemented. In Cambodia, approved investment in 2005 ($1.1 billion) was roughly equal to the cumulative figure for the preceding 5 years, mainly as a result of Chinese investment in the clothing industry. This investment appears to be mainly driven by mounting domestic wage pressure in the PRC, but may also be a safeguard move against the recent US and EU initiatives to curb clothing exports from the PRC (Box 3 [ PDF 102.4KB | 3 pages ]).

The surge in FDI in the aftermath of the policy shift from "plan to market" was a common pattern observed across transition economies worldwide. Significant initial reforms and the general media-propelled euphoria about the opening of a "new investment frontier" naturally heightened investor interest in becoming the first to exploit new investment opportunities. Moreover, in the immediate aftermath of economic liberalization, there were often many quick return but low-risk long-term investment opportunities in infrastructure development and the provision of utilities (power, telecommunication, etc.) and in resource-based sectors (e.g., forestry, hydropower, and mining in the Lao PDR and oil exploration in Viet Nam). Large infrastructure and energy projects, often with the involvement of international developmental agencies such as ADB and the World Bank, have also provided an added impetus for investment in related areas. Once these initial stimuli dissipated, the sustainability of the investment surge hinged on the ability of the governments to deliver on promised reforms and the "natural" attractiveness of the country as an investment location.

The onset of the East Asian financial crisis in mid-1997 acted as an additional factor in the cessation of the post-reform surge in FDI in the CLV countries. Investors from the so-called East Asian ¡°miracle economies¡±-in particular Republic of Korea, Malaysia, Singapore, and Thailand-played a key role in the investment surge on the back of the economic boom in their economies in the lead-up to the crisis. These substantial intra-Southeast Asian FDI flows were severely disrupted by the onset of the financial crisis in mid-1997. Cambodia and the Lao PDR were more affected by this external shock than Viet Nam because of the dominance of regional investors in these countries. In addition to this direct effect, the financial crisis also had a damaging impact (at least in the short to medium term) on investor bullishness about East Asia in general as a favored investment location.

The role that the Asian financial crisis played in the drop-off in post-reform FDI flows to these countries should not be overstated however. For instance, a close look at investment approvals data in Viet Nam suggests that investor interest in that country began to decline from about mid-1996. This had more to do with the legislative assembly not delivering on anticipated reforms and domestic opposition to foreign firms on the basis of their perceived adverse socioeconomic implications (Kokko 1997). FDI flows to the Lao PDR began to decline well before the onset of the Asian financial crisis as well. In Cambodia, the political crisis in the mid-1990s had a much more damaging impact on FDI inflows than the Asian financial crisis.

In an overall international comparison, the three countries still remain small players in the global investment scene. In many ways, this should not seem surprising given the transitional nature of these economies and their relatively small size. But even during the investment boom of 1992¨C1995, FDI in Viet Nam amounted to a mere 1.2% of total FDI flows to developing countries. Furthermore, this figure had declined to 0.6% by 2000¨C2005. Total FDI inflows to the three countries during 2000¨C2005 amounted to 0.7% of total FDI inflows to developing countries. During this period, they accounted for 33.4% of total FDI inflows to the GMS region, with Viet Nam accounting for 29.8%, Cambodia 2.9%, and Lao PDR 0.7%. Historically Thailand has been the largest FDI recipient in the region (excluding the PRC) (see Box 4 [ PDF 113.8KB | 3 pages ] below on Thailand¡¯s experience with FDI), but Viet Nam has been catching up in the last couple of years.

Source Country Composition of FDI

The source country composition of FDI to Cambodia, Lao PDR, and Viet Nam is characterized by a clear regional bias. Investors are predominantly from ASEAN, Northeast Asia and the PRC (Table 6). This is in sharp contrast to the other Southeast Asian countries (Indonesia, Malaysia, Philippines, Singapore, and Thailand) where the bulk of FDI originates from OECD countries. Intra-GMS FDI inflows are predominantly from Thailand, PRC, and some Vietnamese investment in Cambodia and the Lao PDR. There is hardly any investment by Cambodian or Lao companies in other countries.

In Cambodia, ASEAN investors accounted for 54% of total foreign investment (with Malaysia alone accounting for 44%), Northeast Asia 26%, and OECD countries 20%, during 1994¨C1999 (Table 7). Since then, the composition has shifted strongly in favor of Northeast Asia. In 2005, 76% of total investment was accounted for by investors from Northeast Asia, with Chinese investors alone accounting for 66%. This was accompanied by a decline in the ASEAN share to 19% and the combined OECD share to a mere 4%. Most Chinese investment is in the garment industry. Recently, two Chinese companies have applied to invest in oil refining. There has also been Chinese interest in investing in hydroelectricity, railway, and oil and gas exploration. In April 2006, the PRC provided a further $600 million in aid and soft loans for the construction of bridges, a hydropower plant, and government offices. Some commentators fear that the PRC¡¯s newfound enthusiasm in investing in the country may distract attention from much needed reforms to improve the overall business environment.

In the Lao PDR, investors from ASEAN countries accounted for over 55% of total approved investment in the early 1990s, with Thailand alone accounting for more than half (Table 8). The ASEAN dominance dissipated during the ensuing decade, but not as fast as in Cambodia. By 2005, ASEAN investors still accounted for over 40% of total investment. The relative importance of the PRC and Republic of Korea as source countries has increased sharply in recent years, but the combined non-ASEAN share is still small (18% during 2000¨C 2004) compared to Cambodia. Unlike in Cambodia, the share of OECD countries has increased consistently, from 15% in 1988¨C1994 to 32% in 2000¨C2004. This is mostly a reflection of large and lumpy investments by Australian and French companies, in particular, in mineral and hydropower projects.

The source country composition of FDI in Viet Nam is much more diversified, reflecting a wider range of investment opportunities available in a larger economy (Table 9). Over the years, the relative position of ASEAN countries as sources of investment has declined while the portance of investors from other East Asian and OECD countries has grown. During 2000¨C 2005, Northeast Asia and the PRC accounted for 44% of total approved investment, with OECD and ASEAN countries accounting for 36% and 20%, respectively. At the individual country level, the relative position of Singapore, which was the largest investor until 1999, has declined (from 16% during 1988¨C1999 to 12.5% during 2000¨C2005) and that of Republic of Korea and Taipei,China has increased (from 9% to 16%, and 12% to 23%, respectively). Investment from the PRC has increased rapidly, but from a low base, reaching 4% of total investment during 2000¨C2005.

During the early years of market-oriented reforms in Viet Nam, analysts often referred to e US economic embargo as a major constraint to the country¡¯s ability to rely on FDI in the process of economic transition. However, the lifting of the embargo in 1994 and the signing of the Viet Nam-USA Bilateral Trade Agreement in 2001 has not yet ushered in a significant change in the source country composition of FDI in Viet Nam. It may, however, have had positive demonstration effects on other countries. The US share in total approved investment amounted to a mere 1.5% during 2000¨C2005. This tepid response from US investors so far seems to suggest that the domestic business environment is the ultimate determinant of the country¡¯s ability to attract investors from the US, whose comparative advantage in international production lies mostly in high-tech and heavy industries. In particular, US FDI in countries in the Asia-Pacific region is heavily concentrated in assembly activities in vertically integrated hightech industries. Investors in these product lines place a much greater weight on the stability and transparency of the domestic investment climate than do investors coming into less complex labor-intensive product lines. The domestic business environment may improve as Viet Nam implements further reforms under the Bilateral Trade Agreement and in anticipation of the impending accession to the WTO. In this respect, the recent decision by Intel to set up a large electronics component assembly plant in Viet Nam is encouraging.

Industry Composition of FDI

At the initial stage (1994¨C1999), FDI in Cambodia was heavily concentrated in the services sector, mostly in tourism (43% of total investment in approved projects). During the ensuing years, the investment share in manufacturing has increased sharply, from an average of 35% in 1994¨C1999 to 59% in 2005 (Table 10). FDI in manufacturing is largely concentrated in the garment industry, with investors from the PRC accounting for over 90% of investment approvals over the past 5 years. The enthusiasm of Chinese investors in expanding investment in the Cambodian garment industry alleviates the widely-held concern that the abolition of the MFA may result in massive export losses. It would appear that producers based in low-wage countries like Cambodia have ample opportunities to expand exports based on relative cost advantage in a quota free world, without the fear of being subject to punitive tariffs imposed by the US, EU, and other importing countries.

In the Lao PDR, the industry composition of FDI is dominated by the mining and electricity (hydropower) sectors (Table 11). In recent years, the share of agriculture and forestry in FDI approvals has also increased substantially, partly reflecting interest in plantations (see footnote 6). It is generally believed that there is ample potential for the Lao PDR to attract more FDI into the mining sector. For instance, only 25% of land area has been geographically mapped. Hydropower is also likely to remain one of the key sectors for FDI given expanding demand from neighboring Thailand, as well as Cambodia and Viet Nam. The share of manufacturing in total approved FDI has remained around 10%, the lowest among the three countries. The Lao PDR has not benefited as much as Cambodia from new investment in its clothing industry following the abolition of the MFA. Nevertheless, quota-hopping foreign investors who entered the garment industry in Lao PDR during the MFA era have not left and a few investors, including at least one Japanese firm, have recently applied for approval to set up plants to produce garments for export to niche markets.

In Viet Nam, extraction of crude petroleum and gas, and construction and services sectors were the initial areas of interest to foreign investors, with the manufacturing sector accounting for less than a fifth of total approved projects (Table 12). The relative importance of manufacturing has been increasing over the years however. By 2005, manufacturing accounted for 42% of cumulative approved investment in realized projects. During the early years, much of FDI in manufacturing was market-seeking, or production that catered to the domestic market. During 1988¨C1990 for instance, more than 80% of approved projects had export-output ratios of less than 50%. From the late 1990s onwards, there has been a notable compositional shift from domestic market-seeking to efficiency-seeking export-oriented production in manufacturing. By 2000, over 70% of approved FIEs in manufacturing had export-output ratios of 50% or more, with the majority clustering within the 80¨C100% range. Until recently, most of the export-oriented FDI projects were in garment, footwear, furniture, and other wood products industries. Over the past 5 years, however, MNEs have begun to invest in assembly activities in the electrical and electronics industries.

The decline in FDI during 1998¨C2002 was largely confined to non-traded goods sectors (construction, in particular), and import competing (domestic market oriented) manufacturing. FDI flowing to the export-oriented industries has continued to increase, albeit at a slower pace than in the early 1990s. The share of export-oriented projects has persistently increased from about 1997. The explanation seems to lie in Viet Nam¡¯s strong comparative advantage in international production in labor-intensive production and assembly activities. It may also be that export-oriented FIEs are more resilient to adverse developments in the domestic policy scene, so long as the trade policy regime assures uninterrupted access to imported inputs.

Spatial Distribution of FDI

In all three countries, FIEs have so far been concentrated in the capital city and a few other urban centers, despite specific incentive schemes and special investment zones designed to achieve a wider spatial distribution. In the Lao PDR, although resource-based sectors are by their nature located away from urban areas, according to investment approval records, twothirds of all firms in the industrial sector are located in Vientiane (the capital), Savannakhet, Champassak, and Luang Prabang. Two thirds of all large manufacturing enterprises are located in Vientiane itself. The concentration of approved projects in the capital city of Phnom Penh and surrounding areas seems to be even greater in Cambodia.

Table 13 presents data on the spatial distribution of approved investment in operational projects in Viet Nam. There has been a heavy concentration of projects in the South East [mainly Ho Chi Minh City (HCMC)] and in the Red River Delta (around Hanoi). These two regions accounted for 61% and 28%, respectively, of the total cumulative approved investment during 1988¨C2005. HCMC alone accounted for over a fifth of this investment. There has not been any notable change in the spatial distribution of FDI over the past 2 decades. There is little evidence that the Government¡¯s incentive schemes have encouraged foreign investors to move to remote regions.

The spatial distribution of FDI in all three countries points to the importance of transportation and other infrastructure facilities, and access to administrative services, in determining investment location decisions. Until such physical and social infrastructure is improved in other regions, FDI is likely to continue to be concentrated in and around the major cities.

Economic Impact

A systematic comparative analysis of the economic implications of FDI in the three countries is constrained by a paucity of data. This is particularly the case for Cambodia and the Lao PDR. Unlike in Cambodia and the Lao PDR, the investment monitoring organization in Viet Nam, the Ministry of Planning and Investment (MPI), collects information annually on the operation of approved projects, and the General Statistics Office (GSO) conducts an annual census of industry based on a well-designed and comprehensive questionnaire. For this reason, this section largely focuses on the Vietnamese experience, and reports empirical estimates of various impacts using both published and unpublished data from MPI and GSO. The section then provides some tentative observations on the experiences of Cambodia and the Lao PDR based on the limited data that is available. Finally, the section considers some of the potential negative social and environmental impacts of large projects and measures to mitigate them, using the Nam Theun II project in the Lao PDR as an example.

Viet Nam

1. Impact on GDP and its Domestic Components
   
   FDI has undoubtedly made a significant contribution to the process of economic transition in Viet Nam (Table 14). The share of foreign invested enterprises (FIEs) in GDP increased from 6.3% in 1995 (the earliest year for which such information is available) to 15% in 2003, and they accounted for over 20% of the total increment in real GDP between these two years. The share of FIEs in gross industrial production increased from 25% in 1995 to 36% in 2003, accounting for over 30% of the total increment in gross industrial output between these 2 years.
   
   This notable contribution of FIEs to expansion in GDP and industrial output seems to have occurred against the backdrop of a consistent decline in the share of FIEs¡¯ gross domestic capital formation in the economy, from 32% in 1995 to 18% in 2003. There are two possible explanations for this. First, it may be that efficiency of factor usage (productivity growth) in FIEs has improved over time (see below). Second, the decline may be a reflection of the increase in FIE involvement in export-oriented production, which tends to be more labor-intensive.
2. Impact on Employment
   
   In 2003, FIEs accounted for 15% of total industrial employment (up from 12% in 2001) and 23% of total female employment (up from 16.3%) in the country. The increase in the share of women workers in total FIE employment coincides with the increased export orientation of FIE production. Further information on the patterns of employment in FIEs in the industrial sector is given in Table 15. Total industrial employment in FIEs increased at an annual rate of 23% during the 4-year period from 2000 to 2003, compared to 8% growth in employment in non- FIE (pure local) firms. FIEs also contributed to over 44% of the increase in total industrial employment between 2000 and 2004. The average wage of FIEs has been consistently higher than that of non-FIEs across most industries. If foreign firms have higher productivity growth than domestic firms (see below), then they have the capacity to pay higher real wages than do domestic firms, assuming that workers are paid according to their marginal product. Thus, domestic workers employed in foreign firms could earn higher real incomes, and make a greater contribution to real GDP, than their counterparts in domestic firms (Menon 1998).
   
   While employment in FIEs has increased notably, their share in industrial employment has persistently lagged behind the share in gross industrial output (Table 14). This seems to reflect the capital intensity bias infused into FIE production through the heavy-industry emphasis of the investment approval policy in the 1990s, and the continuing domestic market bias in the trade policy regime. Despite the recent expansion in labor-intensive export oriented product sectors, the output composition of FIEs is still dominated by highly capital-intensive sectors promoted by the protectionist trade regime. For instance, chemical, metallic and non-ferrous minerals, fabricated metal products, consumer electronics and motor vehicle production accounted for over 70% of total output, compared to a combined employment share of less than 20%. There are signs that, with the continuing increase in the relative importance of export oriented ventures among FIEs, the employment potential of FIEs has begun to improve. Of particular significance in this connection is the growing importance of assembly activities in the global electronics industry and other high-tech industries as an area of involvement for foreign the East Asian success story in this sphere.
3. Impact on Exports
   
   The most visible contribution of FIEs to the Vietnamese economy is in export expansion. The share of FIEs in total non-oil merchandise exports increased from 2.5% in 1991 to 30.2% in 2000 and 43.5% in 2005 (Table 16). The role of FIEs is especially important in some key export industries, such as footwear, where they accounted for over three-quarters of total exports, garments and textiles (35%), and electronics and electrical goods (mostly components) (95%).
   
   Table 17 provides data on the commodity composition of exports by FIEs. The patterns emerging from the data are basically consistent with the typology developed in Section A. Contrary to the expectations of policy planners, FIEs in so-called heavy industries such as chemicals, basic metal products, fabricated metal products, and motor vehicles have not begun to make a significant contribution to exports, despite special incentives linked to export performance requirements. The standard labor-intensive goods (in particular garments, footwear and wood products) dominated the export composition to begin with. From about the late 1990s, exports of parts and components of office, accounting and computing machines, electrical machinery and apparatus and other machinery have begun to gain importance.
   
   This important structural shift in export composition highlights the role that FDI is playing in linking Viet Nam to the ongoing process of product fragmentation in global manufacturing. However, small and medium scale assembly plants have dominated this product line so far. The only significant large scale player is Hitachi, which runs an assembly plant in the South and employs over 4,000 workers, although in January 2006 Intel announced plans to invest $600 million in a chip making plant. So far, Viet Nam has not been able to attract any of the other major electronics MNEs that played a significant role in the electronics revolution that occurred in countries such as Singapore, Malaysia and, more recently, the Philippines.
4. Impact on Productivity Growth
   
   FIEs are expected to contribute to productivity growth both directly, through their role as part of the domestic economy, and through spillover effects on the performance of domestic firms. In the remainder of this section, we undertake a preliminary analysis of the direct productivity implications of FIEs in Vietnamese manufacturing using data at the two-digit industry level for the 4 years from 2000 to 2004 tabulated from unpublished returns to the annual Industrial Census conducted by the General Statistics Office (GSO).
   
   The most widely used indicator of factor productivity is labor productivity (LP), measured as valued added per unit of labor input. Growth of labor productivity refers to an increase in the value of goods produced by the average worker (or the increased efficiency of the average worker). In reality, workers may produce more not only because of an increase in efficiency but also because they have more inputs (capital, in particular) to work with. Thus LPG could spuriously capture changes in capital per worker as part of measured productivity. Total factor productivity growth (TFPG)¡ªthe residual output after accounting for growth in all factor inputs¡ª avoids this problem and this is a preferred productivity measure. However, it is important to check the sensitivity of the results to the use of LPG in place of TFPG, because the former is the most widely used indicator of factor productivity.
   
   Estimates of labor productivity growth (LPG) and total factor productivity growth (TFPG) are reported in Table 18, together with some supplementary data to facilitate the interpretation - of results. There is a sharp contrast in productivity performance of FIEs during 2000¨C2003 in terms of the two alternative indicators. LPG of FIEs in total manufacturing contracted at a compound rate of 2.4% during this period in a context where LPG of all firms remained virtually unchanged. By contrast, TFPG of FIE production increased at a compound rate of 2.2% compared to a mere 0.6% increase recorded by pure local firms and 1.2% by all firms. At the disaggregate level, FIEs¡¯ contribution to productivity improvement is particularly impressive in office, accounting and computing machines (11.1%), electrical machinery (9.8%), and other transport equipment (17.9%)¡ªindustries which have become increasingly export oriented over time. By contrast, in most of the domestic-market oriented heavy industries, where FDI participation was encouraged by the government at the initial stage of reform, productivity growth in FIEs is either negative or near zero. Moreover, in these industries there is no notable difference in productivity performance between FIEs and local firms.
   
   The difference between measured LPG and TFPG for FIEs points to an important on going structural change, which is the decline in the capital intensity of production. In total manufacturing, the degree of capital intensity of FIEs declined at an annual compound rate of 5.1% during this period (whereas capital intensity of local firms increased by 2.9%). By contrast, TFPG is negatively related with the change in capital intensity (whereas labor productivity growth is positively related with capital intensity). As already noted, the decline in capital intensity is a reflection of increased export orientation of FIE production.

Cambodia

The experiences of Cambodia and the Lao PDR also point to the important role that FDI has played in export expansion and employment generation. In Cambodia, the clothing industry is entirely foreign-owned. Clothing exports have been the major foreign exchange earner for the past decade or so (Table 19).

Direct employment in the garment industry in Cambodia increased from an estimated he urban-rural income gap. 19,000 in 1995 to nearly 200,000 in 2003. In addition, an estimated 150,000 workers are indirectly employed by being involved in associated activities (CDRI 2005, p. 66). The clothing industry is now the second largest employer in this predominantly agricultural country. Over 85% of workers in the industry are women and over 90% of them come from rural areas. If overtime work is included, a garment worker could earn about $60 per month, an attractive salary by Cambodian standards. It is estimated that these workers remit about 50% of monthly wages to family in rural provincial areas. In this way, the rapid expansion of FDI-driven clothing exports has become a major vehicle for the empowerment of women, improving livelihoods, and narrowing t

In recent years, FDI has also begun expanding into other labor-intensive export lines, such as shoes, toys, and wood products. As FDI-driven exports in these sectors increase over time, significant inroads can be made in addressing underemployment and poverty in Cambodia.

Lao PDR

In the Lao PDR, the FIE-dominated hydroelectricity industry accounted for more than 40% of total current account receipts in the balance of payments in 2004. Foreign-owned factories account for most of clothing exports, which in turn constitutes more than 90% of total manufactured exports. Although there are no FDI-related employment figures for the Lao PDR, a tentative estimate based on investment approvals suggests that around 60,000 workers are currently employed in FIEs.

A major factor that needs to be taken into account in assessing the developmental gains from FDI in the Lao PDR is the relatively heavy concentration of FIEs in the mining and hydroelectricity industries, as well as in forestry. Conservative estimates show that as many as 150,000 hectares may be under industrial plantation by 2015, creating assets in the form of productive plantation land, and providing the poor with an important source of cash income and sustainable livelihood. The Nam Theun II hydroelectric power project, which is to be commissioned by 2009/10, not only has the potential to alter the FDI landscape of the country, but will provide significant benefits to the economy of the Lao PDR. The large foreign investment inflow, estimated at approximately $1.3 billion, is expected to generate a sizable income stream for the next 3 decades and beyond. Through taxes, royalties and dividends, the people of the Lao PDR stand to be significant beneficiaries, as long as these revenue streams are well managed. The construction phase will directly employ about 4,000 people, with more than double (perhaps even quadruple) this number of jobs expected to be created as a result of support services and other multiplier effects. Poverty in the site area is severe and the project has the potential to open the area to eco-tourism and promote commercialization of agriculture through access to markets via improved infrastructure. More generally, GDP growth could be spurred by a full percentage point, which could help to raise some 60,000 people nationwide above the poverty line.

Commissioning of the project in 2009/10 will strongly boost export and foreign exchange earnings. Apart from its contribution to exports and foreign exchange earnings, the Nam Theun II project will also promote economic and social development by providing reliable and leastcost power supply domestically. Electricit¨¦ du Laos (EdL) has made a prudent commitment to purchase at least 200 gigawatt-hours (GWh) from the project but has the option to purchase up to 300 GWh to meet domestic demand.

Potential Negative Impacts of FDI

The discussion so far has highlighted the positive impacts that FDI can have in host countries. Large investment projects involving the exploitation of natural resources in particular can have a range of negative social and environmental impacts however. Although this does not necessarily depend on the source of funding©¤whether domestic or foreign©¤these costs are real and can be quite significant. The Nam Theun II project in the Lao PDR provides a useful illustration of such costs, since they are likely to apply to most large projects not only in the hydropower sector but also other forms of resource-based industries. For this project, the principal adverse environmental impact is likely to be the loss of habitats (both terrestrial and aquatic) in and around the project site area. This loss of habitat will increase population pressures on wildlife that are dependent on these habitats. There are water quality issues ssociated with the reservoir and downstream receiving waters as well, which are cross- a boundary in nature. Poor water quality in the reservoir could affect the viability of reservoir fisheries programs, and greenhouse gas emissions from the reservoir could contribute to global carbon dioxide levels.

On the social side, there are resettlement and social dislocation issues relating to the communities that will be displaced directly as a result of the project. Relocation in this case could entail loss of livelihoods (e.g., from loss of fields for rice and other crops and vegetables, forestland, and fishing grounds) and forced changes in lifestyles and associated social stress. Since the majority of those that need to be resettled are from vulnerable groups such as ethnic minorities, the social dislocation cost is likely to be particularly high since they will find it quite difficult to adapt to new living and working environments. The influx of construction workers into the project area could also create potential health, safety, and natural resource management problems.

The Nam Theun II project has in place a range of mitigation and social safeguard measures designed to address these costs. Although such measures may not always be able to fully compensate for such costs, they can go a long way toward minimizing them. In this case, the involvement of multilateral development agencies such as ADB and the World Bank provide further assurance that these measures are likely to be designed and implemented effectively.

Finally, on the economic side, large FDI projects such as these that involve a massive influx of foreign capital raises concerns relating to adverse implications for domestic resource allocation that operate through the appreciation of the real exchange rate, or decline in prices of tradable relative to that of nontradable goods. In the case of Nam Theun II, these effects are expected to be moderate and manageable as the project is essentially an "enclave project". Almost all inputs except labor will be imported, and the Lao PDR is a labor surplus economy. In ther words, it is unlikely that there will be much of a "Dutch Disease" type effect resulting from o this project, and should not have any significant deindustrialization impacts. This is also likely to be the case for most resource-seeking FDI projects in the CLV countries because most, if not all, tend to operate similarly as enclave projects. If, however, the real exchange rate appreciation turns out to be stronger than anticipated, then a sensible policy response would be to accelerate trade liberalization to ensure that the competitiveness of the tradable goods sector is not significantly harmed.

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.