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Foreign direct Investment in Southern Africa

EXECUTIVE SUMMARY

Introduction


This paper presents the findings of a study analysing the major factors determining the form and volume of private foreign direct investment in Southern Africa. This study aims to ascertain (i) what are the primary motivations for investment in Southern Africa and (ii) whether the form of new foreign investment influences its developmental effects. By assessing the motivations for direct investment in the region and the extent to which FDI contributes to new employment and to skills transfer, it seeks to shed light on appropriate policies to pursue in order to encourage higher volumes of FDI and their likely implications for economic development. FDI is one element linking Southern Africa to the global economy. The volume and forms that can be attracted will influence whether Southern Africa’s poor can benefit from globalisation of markets.

Lessons from theory and experience

Determinants of private (domestic and foreign) investment

The economic literature on private capital formation in developing countries is largely concerned with the issue of uncertainty and risk as disincentives to investment. Macroeconomic instability is found to be a disincentive as is the presence of large external debt burdens. The variability of both the exchange rate and the rate of inflation - more than their levels - causes investors to hesitate to commit significant resources. Uncertainty about the future will dominate decisionmaking, even when potentially profitable opportunities exist. For this reason, lags in the investment response to macroeconomic adjustment can be very long. Political uncertainty exacerbates perceptions of a fragile investment climate.

Determinants of foreign direct investment

Multinational enterprises may base FDI decisions on one or more of the following factors: a secure and cheaper source of regularly required inputs; the desire to defend or expand markets or service existing clients in a particular foreign region; the wish to rationalise production into a network of the most efficient production bases supplying the largest possible worldwide market; and other strategic considerations with respect to the firm’s international position. These can be summarised as providing two distinct motives for FDI: market access and production costs. The former derives from the gain of being close to consumers, and tends to be associated with distribution outlets and/or production purely for the local market. The second arises from the benefits of being able to base production in low-cost locations, and tends to be correlated with export orientation.

Foreign direct investment in Africa

Although these determinants apply generally to multinational investment, there are features particularly important to Africa which should be taken into account. The indicators which have been found most frequently to be correlated with increased FDI in Africa in cross-country empirical analyses are: economic openness, especially to international trade; the quality of institutions and physical infrastructure in the host economy; and economic growth and stability. Investor surveys in Africa have tended to emphasise economic instability and institutional weaknesses as the main barriers to increased levels of FDI.

The developmental effects of FDI

The developmental benefits of FDI are not automatic, and mechanisms may be required to ensure that the expected benefits of FDI are equitably distributed in order to make a positive impact on poverty alleviation and social welfare. Possible developmental benefits include employment creation, the promotion of forward and backward linkages in the host economy, the development of human capital, the implementation of internationally acceptable codes of employment practice, improving the access of the host economy to world markets, and augmenting corporate tax revenues.

FDI in Southern Africa: an overview

The experience of SADC members in attracting long-term capital flows has been mixed. In US dollar terms, the amount of FDI received by SADC is a small fraction of total flows to low and middle income economies: between 1995 and 1999, the approximate share of SADC in total FDI to developing countries varied between 2 and 3 percent. However, for some countries in the region, annual inflows expressed as a percentage of GDP have, at times, significantly exceeded flows to other developing economies: for instance Angola in 1998-9; Lesotho and Seychelles in 1995-99; and Mozambique in 1999. This is often explained by a limited number of large transactions in relatively small economies, including investment in natural resource exploitation and infrastructure development, and also privatisation transactions. Privatisation has been an important source of FDI for some SADC countries - such as Mozambique, Tanzania and Zambia - but, in general, slow progress in the sales of the largest parastatal entities suggests that there is considerable scope for further inflows of foreign investment over time.

South Africa dominates foreign investment in SADC, receiving a substantial fraction of new FDI inflows into the region and hosting the greatest number of foreign subsidiaries across a broad range of economic sectors. South Africa’s capacity to act as a magnet for FDI in the region, particularly in the context of growing regional economic integration, is an important feature of investment flows.

Determinants and characteristics of FDI in Southern Africa

The analysis in this study draws on a survey conducted with (predominately) European parent companies with operations in SADC. This survey aimed to explore the following issues: motivations for investment; the market orientation of subsidiaries in Southern Africa; decisions on expansion versus contraction and implications for employment; the ownership structure of investments; the method of entry into the host economy; the impact of economic policy on operations in SADC; and perceptions of risks.

Motivations for investment

The most important motivation for investment in Southern Africa is the size of the local market. Most of the non-primary sector enterprises in the sample have a local market focus, and few are seeking to develop export capacity to markets outside the region in the medium term (the exceptions are all located in South Africa). The creation of a functioning free trade area is likely to provide the economies of scale needed for profitable production, and thus should encourage more direct investment in the region. South Africa - the largest domestic market in Southern Africa - is seen by many investors to be pivotal for regional production and trade.

Other important motivations for investment include the presence of natural resources; historical links with Africa; privatisation programmes or public-private partnership schemes; and - for several service sector firms - strategic factors associated with servicing global corporate clients. Firms with long-standing historical links are more likely to remain in times of uncertainty, even when new firms might be deterred from entry, and may be significant sources of additional investment over time.

As a motivation for location in Southern Africa, market seeking is more important than cost considerations. South Africa is more attractive than its neighbours for secondary- and tertiarysector enterprises, and it acts as a base for production for the region and, in some cases, for exporting to the rest of the world. The main location-specific reasons for this pattern is superior infrastructure, physical and financial, and the fact that South Africa is by far the largest economy.

Enterprise growth and employment

Half of the firms interviewed in this survey increased the scale of (existing) operations in the past five years, and just over half are planning expansion in the next five. However, enterprise growth is not always accompanied by employment growth. In manufacturing, rising capital intensity and improved productivity may limit the benefits of FDI in terms of ongoing job creation. On the other hand, skills transfer and joint ownership of assets with local partners is taking place in the region, although most firms in the sample tend to prefer to retain management control.

Mode of entry

There is some indication of an increase in the proportion of acquisitions in the last five years, in line with world trends, but the shift is too small to indicate a significant change, and this may be a temporary phenomenon as foreign firms take advantage of privatisation programmes, which necessarily draw in foreign capital via acquisition. Greenfield investment continues to play an important role. Acquisitions tended to occur in the primary sector; while greenfield investments were more likely in the service sector.

Ownership structure

The choice of ownership structure tends to reflect the internal preferences of parent companies with respect to control of their foreign subsidiaries. This is more influential than any factors specific to the host economy or investment project. There is some weak evidence that full foreign ownership occurs more frequently among secondary- and tertiary-sector firms producing for export markets, indicating that control is viewed as important for quality and consistency of supply.

Sources of risk

Foreign exchange and the quality of governance are the most common risk factors identified by this sample of investors. Foreign exchange risks include instability of exchange rates, particularly for those firms producing for local and regional markets, and availability of foreign exchange for importing inputs and repatriating profits. Concerns about quality of governance cover a range of issues, including the risk of intervention in property rights, corruption, and bureaucratic uncertainty.

Other indicators of economic and political stability do not appear to have any consistent influence on the characteristics of foreign investments in the sample. One reason for this is that economic reform in several countries in the region may still be too fragile and too recent for it to have had a marked effect on private investment behaviour.

Investors frequently argued that the “Africa perception” is a barrier to attracting new firms into the region. Unfavourable perceptions of the credibility of reforms may well have their greatest impact on those multinational corporations which are not yet committed to investment in Africa. In other words, the view that instability is endemic across Africa, serves to undermine efforts to attract potential FDI to the region.

Policy implications

Market orientation: local markets and regional integration

The primary reason for locating in Southern Africa is to take advantage of the local market. Most of the non-primary sector enterprises have a local market focus, and - with the important exception of several firms located in South Africa - these enterprises are not seeking to develop global export capacity in the medium term.

Market size is influenced by the number of people to whom goods can be distributed and the volume of their disposable income. Where domestic markets remain small, only a limited number of foreign investors are likely to enter. Economic growth to increase the size of the local market may therefore need to be a precursor to higher levels of FDI.

In the meantime, a functioning and sustainable free trade area is more likely to offer the economies of scale required for investment to be profitable, and thus should encourage more direct investment in the region. There is a risk that much of the FDI flowing into SADC will locate in South Africa. Regional initiatives thus need to be designed carefully to ensure the benefits of new FDI are broadly spread across the region. Where core economies attract most foreign direct investment from outside the region, intra-regional resource flows may be encouraged by the removal of exchange controls, particularly on FDI. This will enable private capital in larger economies, especially South Africa, to seek profitable investment opportunities in neighbouring countries.

Infrastructural development on a regional basis is a further mechanism for enhancing gains from the FTA for the smaller economies and may also, in the longer term, help to encourage a more even distribution of extra-regional FDI. The smaller economies in the region need to develop financial, electronic and physical infrastructure in order both to stimulate domestic investment as well as attract foreign capital.

Market orientation: creating export capacity

Existing markets, particularly local markets, remain the main focus of activities for most of the enterprises in the sample. Where outward orientation of existing enterprises has either taken place or is planned, these are all located in South Africa. For the smaller SADC economies, the domestic market is too limited to generate significant endogenous development. For this reason, it is crucial that production be aimed at a wider market, both regional and global.

Faster capital accumulation is vital, requiring a reduction in the risks to private investment in both physical and human capital. Risks vary across countries but policy measures include conflict resolution, greater political and macroeconomic stability, better legal systems and less corruption. This policy agenda is common to all developing regions irrespective of factor endowments. Where African economies face a particular challenge is in addressing the apparent perceptions of potential international investors that political and economic instability is endemic.

Investment in education, training and research will be crucial in developing new industries, as will investment in transport and communications. Expenditure on infrastructure and education is likely to be of greater importance in the long term than tax and investment incentives for investors.

External factors which are crucial include the reform of the world trading system. It is widely recognised that developing countries require greater negotiating capacity, especially in international fora. Within regional frameworks such as SADC or wider efforts such as NEPAD, cooperation in building a united position on trade negotiations will support a strengthening of such capacity.

Perceptions of risk

The primary disincentives to locating in the region are perceptions of poor governance, volatile exchange rates and/or a lack of access to foreign exchange.

Where volatile exchange rates are symptomatic of macroeconomic instability, the priority must be economic stabilisation. The phasing out or scaling down of exchange controls on non-residents in those countries where they remain, together with ensuring the availability of foreign exchange is essential to attracting investment. Foreign exchange availability is particularly important in terms of acquiring imported inputs and repatriating post-tax profits.

Predictable economic policies and political responses can be considered a prerequisite for FDI. Countries need to be some way along the economic transition route to attract FDI, and lags in the investment response to reforms may be very long, particularly where investors are concerned with the credibility and sustainability of policies. Finally, government regulations and procurement policies may deter some forms of FDI, particularly where they affect ownership. Governments need to weigh the benefits of such micro-level interventions against the costs of erecting perceived impediments to FDI.

Many of the motivations influencing the investment decisions of multinational companies apply equally to domestic investors. Addressing the problems identified by foreign investors already committed to the region should not only in the long run make Southern Africa more attractive to new FDI but should in the shorter term encourage increased domestic investment.

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