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The factors that stimulate the flow of FDI

1.0 Introduction

The growth of international production is mainly driven by economic and technological forces. It is also driven by the ongoing liberalization of Foreign Direct Investments (FDI) and trade policies. Foreign Direct Investments (FDI) refers to an international investment made by a resident entity in one economy (Direct Investor) with the objective of establishing a lasting interest in an enterprise.

Globalization offers exceptional opportunities for developing countries to achieve a rapid economic growth through trade and investment. Foreign Direct Investment is considered as a major incentive to economic growth in developing countries, as it contributes to host country economic growth, by enhancing the country’s capital stock, introducing complementary inputs, inducing technology transfer and skill acquisition, or increasing competition among local industries. But only a few countries have been successful in attracting significant FDI inflows to their country owing to so many reasons.

FDI bring forth much needed resources to developing countries such as capital, technology, managerial skills, entrepreneurial skills, brands and access to new markets etc. These are essential for a developing country to industrialize, develop and create jobs attacking the poverty situation in their countries. As such most developing countries recognize the potential value of FDI and have liberalized their investment regimes and engaged in investment promotion. Globalization and regional integration arrangements can change the level and pattern of FDI and also it reduces the trade costs. However, FDI flows to developing countries started to pick-up in the mid 1990s largely as a result of systematic increase in liberalization of FDI policies in these countries and the adoption of generally more outward oriented policies.

This report attempts to address the impact of FDIs towards the development of a nation, determinant factors of attracting FDIs and issues faced by the host countries in attracting FDIs. At the latter part of this report include recommendations to host country government to adopt towards foreign investors, in order to promote economic development. For the purpose of identification of issues and addressing of recommendations Sri Lanka, a developing country that keeps rely on FDIs is taken in to consideration.

2.0 Host country determinants that influences the inflow of FDI’s

FDI decisions depend on a variety of characteristics of the host economy,

Size of the Market

There can be seen a well well-known relationship between FDI and the size of the market and as well as with some of its characteristics (e.g. average income levels and growth rates). When the GDP of a country is relatively small, it is an indicator of low level of national income. As such investors prefer to invest in countries where there is a high growth potential and where there is a large market for their products and services.


Even though the investors pay attention on the size and the growth of the market as important, all the other domestic market factors are predictably much less relevant in export oriented foreign firms. Wide spread insight is that open economies encourage more foreign investment. One indicator of openness is the relative size of the export sector. Particularly manufacturing exports are a significant determinant of FDI inflows. Investors prefer countries where there are lenient rules and regulations in relation to foreign trade.

Labour costs and productivity

Labour cost is a significant factor for foreign investors specially when making their investments in labour intensive industries and for export oriented subsidiaries. (For an example opening up garment factories, export processing firms where larger number of employees is required) Low wage rates heavily stimulate investors to make their investment decisions in a particular country. How ever when the cost of labour is relatively insignificant (when wage rates vary slightly from country to country) the skills of the labour force are expected to have an impact on decisions about FDI location

Political Risk

High returns in the extractive industries seem to compensate for political instability. In general, as long as the foreign company is confident of being able to operate profitably without undue risk to its capital and personnel, it will continue to invest. Large companies overcome some of the political risks by investing in their own infrastructure maintenance and their own security forces. But these companies are restrained by small local markets and exchange rate risks since they tend to sell exclusively on the international market. If a country is vulnerable to a higher degree of riots, labour disputes, and corruption and if it possesses greater criminal level, those will be the determinants that restrain foreign investments.

Infrastructure Facilities

Infrastructure covers many dimensions ranging from roads, ports, railways and telecommunication systems required to institutional development (e.g. Legal services, accounting etc.) The extent of transport facilities and the proximity to major ports has a significant positive effect on the location of FDI within the country. Poor infrastructure can be seen both as an obstacle and as well as an opportunity for foreign investment.

Incentives and operating conditions

Removal of boundaries and provision of a healthy environment for businesses that consists of better operating conditions, lower tax rates or tax holidays are generally believed to have a positive impact on stimulating FDI. Further incentives such as the granting of equal treatment to foreign investors in relation to local counterparts and the opening up of new markets (e.g. air transport, retailing, banking) have been reported as important factors of encouraging FDI flows to a particular country.


Through privatization it has attracted some foreign investment inflows in recent years. But when moving on to most of the developing, low income countries progress is still low due to divestments of state assets. This has become political issue that demotivate investors. For an example employee resistance and their aggressive actions over privatization or other moves which threaten their existing jobs and worker rights may act as a deterring factor of FDI.

3.0 Issues to attract FDI

Majority of the low income countries including Sri Lanka fail to attract large FDI flows in to their countries as domestic markets are small in size. Investors are reluctant to install their factories if they are unable to attract a critical mass for their products.

Impossibility of attracting FDI due to lack of openness in the economy as the export manufacturing sector is governed by rigid rules and the issues faced by the industry due to lack of or abolishing of quota.

Labour market rigidities and high wage rates in the formal sector with comparison to other countries like china, Vietnam is often viewed as a deterring factor in order to attract significant in flows in to the export sector in particular. Lower productivity with comparison to countries like China and countries in sub Saharan Africa and lack of engineers and technical staff is reported as holding back potential foreign investment, especially in manufacturing exports sector. Further it lessens the attractiveness of investing in productive sectors.

Higher level of labour disputes, strikes, riots, corruption in the country and as well as some of government rigid policies inefficiency in the public sector are the causal factors that prevent investors from investing in Sri Lanka.

Poor infrastructure can be seen as an obstacle to attract FDI to lower income countries like Sri Lanka. Host government can attract significant FDI by permitting more substantial foreign participation in the infrastructure sector. In Sri Lanka even tough there is a significant increase in FDI in telecommunication and air lines. Other more basic infrastructure such as roads, buildings remain unattractive reflecting both he low returns and higher political risks of such investments.

Even though the government has removed certain restrictions recently, which has been imposed earlier on FDI, the lack of transparency, excessive delay in investment approval procedures, lack of clear cut policy for investment approval and extensive bureaucratic systems are still act as deterring factors of foreign investments.

Due to employee perception regarding foreign employers and their aggressive actions against privatization and tendency towards state own enterprises act as a barrier to attract foreign investors. Further a number of structural problems are constraining the process of privatization. Slow growth and lower level of competition in financial markets which has been characterized by inefficiencies, lack of depth and transparency and the absence of regulatory procedures as those are still continued to be dominated by government activity and are often protected from competition.

Even though the attitudes of the civil society on the impact of FDI on opportunities for domestic business and economic activities is positive and the net attitude of foreign firms toward FDI reveals that the investment climate has not improved in Sri Lanka as a result of lack of good governance, corruption, political instability and disturbance, bureaucratic inertia and poor low and order situation.

4.0 Overall restrictions in FDI

Most South Asian countries have liberalized equity restrictions on FDI in the services sector to encourage trade under Mode 3, i.e. Trade through commercial presence. Taking stock of the liberalization of services that has taken place in different countries in the region, in different sectors, substantial unilateral liberalization has taken place under Mode 3 in Sri Lanka.

Though countries are attempting to attract FDI in many of their services, by liberalizing services, the share of the region in global FDI in services is still very low. One of the reasons for this is the existence of barriers to FDI in South Asian countries. There are so many barriers and restrictions at various levels starting from the point of entry that deter investors. Even though there are no restrictions on equity ownership, so many other restrictions are available at the point of entry, stretching from mere notification requirements to outright prohibition of FDI; others may target the operations of firms; while yet another category may restrict the area of ownership and control.

Sri Lanka has opened its services sector to foreign investment. Foreign ownership of 100% equity is allowed in range of services sectors such as banking, insurance, telecommunications, tourism, stock brokerage, construction of residential buildings and roads, water supply, mass transportation, production and distribution of energy, professional services and the establishment of liaison offices or local branches of foreign companies. How ever some of the restrictions still exists, restricting FDI in services even when 100% equity is allowed are, foreign commercial banks are allowed to open branch offices in Sri Lanka subject to an economic needs test and approval by the Central Bank of Sri Lanka. Foreign investors are allowed to hold 100% equity in local banks subjects to limits on individual share ownership. Even though the government has recently privatized state own insurance companies, how ever resident Sri Lankans are prohibited from obtaining foreign insurance policies except for health and travel.

The restrictions may also vary with the nature of the industry. For an example distribution services, restrictions may include performance requirements, zoning regulations, advertisement restrictions etc. In professional services restrictions used are generally of the nature of nationality and residency requirements and lack of recognition of foreign qualifications. There fore even if the equity restrictions are removed, there may be other restrictions that may not allow the inflow of FDI in to the services sector. Please refer Annexure 1 for some existing barriers to FDI in different countries in South Asian region.

5.0 Reasons for Caution of FDI

Even though it is said that FDI has a heavy impact on enhancing the growth and development of a nation, there are several reasons for developing countries to remain with average restrictions in services or to have other barriers to investments in services. Apart from the sensitivity of services with cultural, social, distributional or strategic significance, there are economic concerns too. Among them,

To avoid the risk of foreign investors out competing domestic investors.

Sale of public utilities to foreign firms raises complex issues related to privatization and the regulation of natural monopolies.

Entry by large transnational corporations involves competition policy considerations and many host countries may not feel to deal with technical or legal issues involved.

It is difficult to assess the impact of liberalization in a particular sector, especially if it employees a large number of unskilled people. As such it is important to undertake an in depth study prior to the decision to allow foreign firms. But many countries lack the will or expertise to undertake such analysis.

Most of the foreign investors are monopolies and in any event need to be regulated; domestic regulations are often difficult to put in place.

6.0 Recommendations

Government should focus its attention on obtaining foreign investor participation in developing infrastructure. So far Sri Lankan government acts the role of infrastructure facilitator. But it should consider on attracting FDIs to develop infrastructure sector as well, not only in attractive and most profitable few areas like telecommunication and airlines, but also in constructing of roads, highways, flyovers, rail roads, buildings etc. BOO (Built, Operating, Ownership), BOT (Built, Operating, Transfer), BTO/Turnkey Projects (Built, Transfer, Operate), BLT (Built, Lease, Transfer) and various other mechanisms to enhance the foreign investor participation in this regard.

Government should focus its attention on implementing an open door policy where it encourages foreign investors. It should enhance the quality of the existing Export Processing Zones (EPZ’s) and Free Trade Zones (FTZs) in order to stimulate investors to come and open up their manufacturing or processing plants in Sri Lanka.

Government interference and domination on financial sector should be minimized unless to exercise a control over such institutions to ensure the transparency and proper functioning of them. Existing stock market should be popularized among the general public and should be opened up for foreign investors.

Even though there are no restrictions on equity ownership there are several barriers at the point of entry, stretching from mere notification requirements to outright prohibition of FDI etc. These may deter foreign investors from investing within the country. Thus this fact should be taken in to Account during the policy making process.

It is often criticized the quality of the output of Sri Lankan education system. It is said that there is a mismatch between the employer requirements and the education provided to the students or undergraduates. Thus Higher education policies especially in relation to secondary, tertiary and university education curriculum should be changed in order to meet employer expectations. Adequate training opportunities provided to them in order to recognize and unleash their potentials and skills. Thus more emphasis should be given towards the importance of industry training when constituting higher education policies.

As FDI in services has grown, a number of issues have come to the forefront of policy making. One of the important issues is that attracting FDI in services where it is most desired. i.e. services sectors where domestic capabilities are limited to cater to the growing demand or where the domestic service providers do not have the ability or capacity to provide the required quality of services, as for an example telecommunication, and transport services. As such more concessions to be given for the investors those who are willing to invest in those areas in order to encourage them.

Regulatory frame work to be strengthened in order to attract investors and also to avoid monopolistic situations. Countries without necessary regulatory frame work may loose by rushing in to liberalization. Particularly when a reversal of liberalization is hard to achieve or when liberalization has systemic implications as in the case of financial industry.

Generally, the positive growth effects of FDI have been more likely when FDI is drawn into competitive markets, whereas negative effects on growth have been more likely when FDI is drawn into heavily protected industries (Encarnation and Wells, 1986). As such domestic industries should be strengthened to a degree in order to provide them the ability to compete with foreign investments.

7.0 Conclusion

This report has examined the factors that stimulate the flow of FDI and the issues that limits or restrains a country from attracting FDIs based on Sri Lanka, a developing country that entertains FDI. It is undoubtedly accepted that there is a positive link between FDI and growth. Especially when Sri Lanka concerns a direct and positive growth impact of FDI on the Sri Lankan economy and its growth has not reflected during the past and as well as in the present.

Attitude of the civil society and foreign firm towards FDI in the country is positive. But the investment climate has not improved in Sri Lanka as a result of political instability and disturbance, poor law and order situation, direct and indirect regulatory barriers, political instability and the implied policy instability, poorly developed infrastructure facilities, lower level of human capital, lack of transparency in the trade policy etc. Accordingly the protectionist trade policies, direct and indirect regulatory barriers (that raise the cost of investment to foreign firms, for example it has found that in Sri Lanka about 13 percent of capital costs and 30 percent of profits are lost due to impediments in the regulatory framework), political instability and the implied stability, poorly develop infrastructure facilities, lower level of literacy and investment in human capital too discourage investors. Lack of transparency in the trade policy, discrimination against non-export oriented sectors like plantations and high lending rates are too act as constraints to FDI flows in Sri Lanka.

The importance of FDI can not be overstated, as result, that investment climate in the country must be improved through appropriate measures such as de-regulation in economic activity, increase domestic saving, developing port network, road network, railways and telecommunication facilities etc, creating more transparency in the trade policy and more flexible labour markets and setting a suitable regulatory frame work and tariff structure. Currently Sri Lanka provides an attractive investment regime but the response from the investor has not been very encouraging. If the ultimate objective of the government is to attract FDI for development, poverty reduction and growth, then an appropriate policy mix is necessary to achieve these.

8.0 Annexure

Annexure 1

Table 1: Extent of Liberalisation in Mode 3 in Selected Services


Substantially Liberalised

(100% equity)

Moderately Liberalised

Less than Moderately Liberalised/


Sri Lanka

Banking, Insurance, Telecommunications,

Tourism, Construction,


Professional services.

Shipping and travel

agencies, Freight forwarding, Higher education, Mass


Non Bank Money Lending,

Retail trade with capital

investment of less than $1mn,Secondary education, Air transportation,

Coastal shipping.


Computer and

information services,



Banking, Insurance,

Air Transport, Construction.

Retail trading,

Railways, Real estate,

Professional services like Postal, Accountancy etc.



Banking services,

Legal and engineering consultancy services,

Transport, Construction,

Computer and information services.





Construction, Computer

and information services,

Banking and Insurance services.



Banking, Insurance,


Computer and information


Personal Business Services,

Consultative services.

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