In recent literature, capital flows from rich to poor nations has become a subject for intense debate among development theorists. (Kolstad, 2008) Many development theorists have come to understand that foreign direct investment (FDI) can provide a positive incentive for growth and development in poor nations. The gains from FDI are numerous, and include technological and productivity spillovers, as well as reduced prices for downstream suppliers for domestic firms, increase demand in local labor markets, increased wages, and an increase in revenue streams for the domestic government. (Javorcik, 2004) Thus, understanding why foreign direct investment flows into some developing countries and not others can have a major impact on development policy in many organizations; including multinational organizations, intra-government development ministries, and private sector aid agencies.
In traditional macroeconomic theory, capital flows from countries with a low marginal product of capital to those with a higher marginal product of capital. (Biswas, 2002) In reality however this does not uniformly occur. Furthermore, according to the IMF, “there is no unique and widely accepted theory of foreign direct investment.” (Lizondo, 1990) Classical macroeconomic theory therefore does not sufficiently explain foreign direct investment rates and supplement theories are required. There is a combination of theories that include numerous explanations of foreign direct investment in developing countries. These include, risk reduction (risk diversification) and market size, market imperfections, oligopolistic rivalry and product cycle hypothesis, liquidity of subsidiaries, currency exchange rates, and lastly political stability and domestic tax rates. (Lizondo, 1990) For the purposes of this essay, I will be focusing specifically on risk diversification, currency exchange rates, political variables and domestic fiscal norms –as these have the most applicability to budget transparency.
Clearly, the outlined above determinants of foreign direct investments are all affected by budget transparency. The OECD Best Practices for Budget Transparency (2002) outlines the determinants of budget transparency, and the relevant institutional reforms necessary to maintain fiscal and monetary transparency, while ensuring accurate economic outlooks and protecting against off-budget expenditures. (OECD, 2002) Budget Transparency & Foreign Direct Investment in Developing Countries 2011
Within this essay, I will make the argument that adopting fiscal and monetary transparency, while producing sound economic outlooks and protecting against off-budget expenditures -and complying with these rules in a coherent manner- should reduce the risk of investment in the eyes of foreign entities; which would in turn view increased foreign direct investment more favorably. In order to validate my argument, I will first look at the existing theory behind foreign direct investment, as well as the theory behind budget transparency, and then elaborate on the theoretical and logical link between the two. Lastly, in order to attach these theoretical frameworks to the true state of the world, I will examine a series of case studies. I will examine several states and look at budget transparency within these individual states, analyze the strengths and weaknesses of budget transparency within their government and its subsequent effects on their domestic economies, and then compare the flow of foreign direct investment (net inflows) as a percentage of GDP.
What is Foreign Direct Investment and what are the determinants of FDI
In order to fully understand why foreign direct investment is both affected by budget transparency, and beneficial to developing countries we need a clear working definition of what foreign direct investment actually is. According to the United Nations Development Program (UNDP), foreign direct investment as:
“…investment made to acquire a lasting interest in or effective control over an enterprise outside the domestic economy of the investor… FDI net inflows are the value of inward direct investment made by non-resident investors in the reporting economy, including reinvested earnings and intra-company loans, net of repatriation of capital and repayment of loans.”
Given this definition, in order to understand what determines the flow of foreign direct investment into a developing economy, and how it corresponds with budgeting transparency, we must understand the decision making process of entities wishing to invest in any particular economy. As mentioned in the introduction of this essay, this is more difficult then it appears as the topic is subject to ongoing academic debate. However, some common trends can be picked out of the academic thicket. Budget Transparency & Foreign Direct Investment in Developing Countries 2011
In Determinants of Foreign Direct Investment (2002), Romita Biswas cites, Keefer and Knack (1995), Lee and Mansfield (1996), and Clague (1999) as explaining property rights and –key for our purposes- quality of governance as crucial to explaining net rates of foreign direct investment in emerging and developing economies. There are numerous indicators for this “quality of governance” variable; however for our purposes, the most important is government corruption and off budget expenditures, risk of expropriation by government officials and tax rates- all of which are either mitigated by or influenced directly by budget transparency. In support of these variables, Biswas finds that the introduction and interaction of the “quality of government” variables (again, composed of the above variables) with traditional determinants of foreign direct investment, produces a highly statistically significant effect (5% level) on determining net inflows of foreign direct investment. (Biswas, 2002)
Taking the above into account, we might then explain in more detail the classical determinants of foreign direct investment in developing counties. First and foremost, firms undertake foreign direct investment as a means to mitigate risk. According to an International Monetary Fund working paper produced in 1990:
“…a firm would presumably be guided by both expected returns and the possibility of reducing risk. Since the returns on activities in different countries are likely to have less than perfect correlation, a firm could reduce its overall risk by undertaking projects in more than one country. Foreign direct investment can, therefore, be viewed as international portfolio diversification at the corporate level.” (Lizondo, 1990)
This tells us that entities diversify risk by spreading foreign direct investments -principally in capital- across many countries. Further expanding on this, we can make a small logical step. We can then assume that entities, wishing to diversify risk would assess the risk inherent in individual economies. Rather than just spreading capital over a high number of developing economies, the entity would pick and choose which developing and emerging economies to locate capital in, and prioritize those locations according to domestic risk –as assessed from the factors mentioned in the introduction. This is a crucial assumption because it says a great deal about the nature of economic entities. In principle, it tells us that these actors do not simply look at the marginal product of capital and prioritize foreign Budget Transparency & Foreign Direct Investment in Developing Countries 2011
direct investment accordingly. Indeed, we assume for the purposes of this essay that economic entities wishing to engage in foreign direct investment balance risk along with their marginal product of capital for individual developing economies.
Moving on from assumptions to other classical determinant of foreign direct investment, we can look at the strength of the entities domestic currency, weighted against the strength of the currency of the recipient economy- destination of the foreign direct investment. This theory is based on “capital market theory” and the strength of exchange rates. In essence, the theory proposed by Aliber (1970, 1971) hypothesis that the stronger the domestic currency of the actor wishing to partake in foreign direct investment, against the currency of the recipient economy, the more likely it is that this actor is to undertake foreign direct investment. Further, this theory explains this relationship primarily through the preference of an investor to hold a select currency. (Blonigen, 1997) Numerous studies to test this theory have shown that there is indeed a statistically significant negative correlation between strength of currency and net inflows of foreign direct investment. (Biswas, 2002 & Blonigen, 1997)
Lastly, another determinant of foreign direct investment -which has been studied with mixed results-, is domestic fiscal norms. While the literature on this particular determinant has yielded mixed results, we must still give attention to both the status quo and risk inherent in the fiscal norms of the recipient economy. Given the assumption above -that entities wishing to engage in foreign direct investment assess and quantify the risk of their investments of capital in all individual economies they wish to invest in- we can ascertain that fiscal frameworks play some role in that assessment. Included in fiscal norms are both the tax rates, and the stability of those norms. We can make the assumption that both unfavorable tax rates and instability of fiscal norms will have a negative impact on foreign direct investment. This subject has been partially studied with some encouraging results. In a 2007 International Monetary Fund piece, published in the Journal of Comparative Economics the authors find that the policy environment (including fiscal policy) does have a significant effect on levels of FDI. (Demekas, 2007) Budget Transparency & Foreign Direct Investment in Developing Countries 2011
Before moving to connect the above determinants of FDI with budget transparency theory, I would briefly like to touch on the interconnected nature of the above determinants of FDI as well as to summarize for the sake of clarity. Above, I cite numerous studies that explain risk, fiscal policy, currency strength, and quality of governance as the crucial determinants of foreign direct investment. Furthermore, hidden in the quality of governance index are several factors that some perceptive academics have looked into; namely government corruption, risk of expropriation by government officials and tax rates. Now, as we’ve discussed fiscal policy, corruption, and risk of expropriation have been mentioned and studied as both an independent contributor to foreign direct investment, as well as part of a “quality of government index.” In essence, all of these variables have been studied and in one way or another, and have been found to contribute to net inflows of foreign direct investment. Furthermore, these variables all are directly affected or are altered by the application of budget transparency theory. We will now examine the definition of budget transparency, its application to developing nations, and how the above determinants of foreign direct investment fit into budget transparency theory specifically.
Fitting the pieces together, FDI and Budget Transparency.
In order to accurately and neatly fit the determinants of net inflows of foreign direct investment together with budget transparency, we need to clearly define what budget transparency is, and its applicability to developing economies. Keeping in mind both the aggregate “quality of governance” determinant of foreign direct investment as mentioned in the previous section -and its subsidiary parts- the OECD explains that, “The budget is the single most important policy document for governments.” Furthermore, the OECD explains that budget transparency can be defined, “…as the full disclosure of all relevant fiscal information in a timely and systematic manner.” (OECD, 2002) By maintaining the assumption that, in order to mitigate risk, entities wishing to engage in foreign direct investment prioritize possible recipient economies in terms of their risk and reward, we can see that the level of budget transparency greatly influences many of the key determinants of net Budget Transparency & Foreign Direct Investment in Developing Countries 2011
inflows of FDI at both the aggregate level in the recipient economy, as well as the individual entities decision of whether or not to engage directly a recipient economy. We will now move to accessing individual determinants of net inflows of FDI in terms of budget transparency norms, attempt to tie them to OECD best practices on budget transparency, before finally concluding this section spending some time on the applicability of budget transparency to developing economies.
First, we will talk about the currency determinant of foreign direct investment as it relates to budget transparency. Fundamentally, currency exchange rates are affected by interest rates and the amount currency in circulation –both of which are directly affected by government debt. The budget transparency outline is first and foremost a budget document that is designed to –among other things- impose fiscal disciple on a government. (OECD, 2002) This fiscal disciple influences currency strength by (theoretically) lowering the debt incurred by governments, as well as providing for more accurate revenue forecasts. The OECD outlines the conditions for these outcomes in several key areas. First in section 1 by outlining that the government should provide a comprehensive list of all government activities, a forecast of future and previous fiscal year’s government expenditure and revenue, and a complete list of all government liabilities. (OECD, 2002)
These measures in the OECD guide have been linked to improved fiscal stability and lower debt ratios of governments in developing countries. For instance, Kopits and Craig (1998) assert that, “better-performing countries (those with better debt ratios and higher levels of FDI)… generally follow more transparent fiscal norms.” Similarly, Alesina, Hausmann, Hommes, and Stein (1996) find that budget institutions do affect fiscal outcomes. They explain that more hierarchical (as defined by their index) budget institutions produce lower debt to GNP ratios. From this we can extrapolate that a key condition for entities willingness to engage in foreign direct investment is met by increasing budget transparency, through increasing currency stability as well as balancing government accounts. Budget Transparency & Foreign Direct Investment in Developing Countries 2011
A closely related determinant of foreign direct investment is domestic fiscal norms in the recipient economy. Conceivably, entities wishing to engage in foreign direct investment would evaluate not only the current fiscal conditions of a recipient economy, but also the fluctuations in this fiscal regime. Viewing highly unstable fiscal conditions as a far higher risk, these entities would then prioritize their investments accordingly. Working under this assumption, we can see how the OECD budget transparency guidelines both improve fiscal outcomes, as well as stabilize the budget process, providing for long run fiscal stability. In Fiscal Discipline and the Budget Process (1996) Alesina and Perotti hypothesize that the implementation of budget transparency and a normative budget process should improve long-run fiscal performance. Using these findings as a working assumption, we can draw a clear parallel from specific elements of the OECD Best Practices of Budget Transparency and improved long-run fiscal performance. More specifically, we can see that stipulations corresponding to medium-term expenditure frameworks, and the long-term report of government fiscal challenges –including demographics among other things- should in theory stabilize the budgetary process, and thus the fiscal situation in the long-run.
Lastly, we will turn out attention to a fuzzy term, namely the “quality of governance” indicator used in so many studies, as well as its subsidiary parts. As mentioned in prior sections, the “quality of governance” indicators, as well as its sub components were shown to have a highly statistically significant effect on net inflows of foreign direct investment. This broad index covers many areas of interest; these include variables such as political stability, level of democratization, and the “policy environment.” For the purposes of this essay however, we will be looking at specifically government corruption, the risk of expropriation, and how budget transparency affects these variables, as well as quality of governance in a broad perspective.
Looking at budget transparency and government corruption first, we see that the literature on government transparency and corruption is extensive. In Is Transparency the Key to Reducing Corruption in Resource-Rich Countries(2008), Ivar Kolstad and Arne Wiig explore transparency as a means to push Budget Transparency & Foreign Direct Investment in Developing Countries 2011
developing countries out of the resource paradox. They conclude that, “Transparency can reduce bureaucratic corruption by making corrupt acts more risky, by making it easier to provide good incentives to public officials, and by easing selection of honest and efficient people for public service.” (Kolstad, 2008) This is especially important within the context of developing economies because these economies have a higher probability of being highly resource dependent. Within the context of the OECD standards for budget transparency, expenditure is classified by administrative unit, financial liabilities are more acutely planned for and the development of more thorough employee compensation obligations provides that government administrators are thus less likely to experience gaps or disruptions in compensation. Furthermore, adhering to budget transparency norms reduces the risk of embezzlement of government funds by creating a clear and routine audit framework.
The additional oversight mentioned above can also help to mitigate the risk of expropriation of foreign actors wishing to engage in foreign direct investment. In Democracy, Autocracy, and Expropriation of Foreign Direct Investment (2009), Quan Li explains that “…governments are most likely to expropriate foreign investment when leaders face little political constraint.” While Quan Li works directly with variables found very often in expropriation literature, -namely rule of law, property rights, investment behaviors, and privatization reforms- I would make the argument that budget transparency helps to mitigate the likelihood of expropriation through better revenue stream planning, as well as the imposition of government fiscal norms. Foreign entities are most at risk of expropriation when operating in countries with unstable fiscal balance sheets, which implies both poor budget transparency and inadequate fiscal norms. In recent history, a prime example of this phenomenon was Hugo Chavez of Venezuela ordered the nationalization of oil production operations owned by two foreign firms. According to the International Budget Partnership Venezuela, “lacks information on fiscal activities… including extra-budgetary funds, and quasi-fiscal activities.” (IBP, 2011) This lack of transparency would imply very few constraints on political Budget Transparency & Foreign Direct Investment in Developing Countries 2011
leader’s ability to affect fiscal and economic conditions in Venezuela, which likely contributed to the expropriation of private firms for political purposes.
In summarizing budget transparencies effect on determinants of foreign direct investment, we should briefly note that all of the above factors affect the risk inherent when a foreign entity is deciding whether or not to invest in a recipient economy. Currency considerations, the stability of domestic fiscal norms, quality of governance –more specifically corruption and risk of expropriation- are all mitigated by properly enacted budget transparency measures. Using the OECD’s guide to budget transparency I have outlined which elements of the guide apply to each of the above determinants. Going further, we can talk briefly about the applicability of these reforms within the context of developing economies.
In Budgeting in Poor Countries: Ten Common Assumptions Re-examined (1980), Naomi Caiden challenges many common budgeting assumptions relevant to the context of developing economies. Most importantly for our purposes, are the assumptions dealing with national economic planning and inadequate resources. Caiden explains that national economic planning with regard to budgeting norms should be used to coordinate development objectives. This argument holds merit in that extremely detailed development plans require vast resources, expertise and foresight by governments that are typically short of all three in one way or another. This same argument holds true for countries with a sever lack of resources- both expertise and financial. However, I would argue against this line of thought on the basis that increased foreign direct investment offsets the costs of implementing budget transparency. Increases in revenue, technological and management spillovers (Aitken, 1999), increased productivity of domestic firms, combined with the other benefits of budget transparency, especially with regard to improved fiscal performance and an increase in quality of governance; the benefits should outweigh the costs in the minds of most policy makers.
Budget Transparency and FDI, Case Study evidence from Uganda:
We now move to an in-depth case study of Uganda to show how the effects of budget transparency can directly increase levels of foreign direct investment. Budget Transparency & Foreign Direct Investment in Developing Countries 2011
Uganda is a sub-Saharan African nation that has seen considerable political and economic turmoil over the last fifty years. Throughout much of the 1960s Uganda had a robust economy; however political instability, poor macroeconomic policies by its government, and economic shocks with roots in the global market quickly deteriorated this advantageous economic situation. Due to these factors, chief among them poor macroeconomic policy, the 1970s and 1980s experienced high levels of inflation due to dramatic mismanagement of public debts. (Kuteesa, 2006) The greatest factor in this period of economic destabilization was the government was printing money to finance public sector deficits, which lead to very high rates of inflation. (Mwenda, 2005) As a result of these economic problems Uganda’s net flow of foreign direct investment flat lined at zero percent of GDP. (World Bank) Furthermore, industrial production fell by 3.9% annually from 1983-86. This decline in industry made Uganda more heavily dependent on agriculture which was also experiencing poor performance due to the economic conditions. (Mwenda, 2005)
However, in 1987 Uganda –with the help of the International Monetary Fund, World Bank and other donors- initiated an Economic Recovery Programme whose aim was to, reduce inflation, balance the budget, and implement sound fiscal and monetary policy. (Kuteesa, 2006) These policies had a dramatic effect on the Ugandan economy, producing healthy GDP growth since the late 1980s. With the stabilization of the currency, improved public debt management, and a clear adherence to thoughtful fiscal norms, foreign direct investment began to grow in the few years following the reforms. However, it is very important to note that the Economic Recovery Programme overseen by the IMF and World Bank did not produce immediate rises in foreign direct investment. Indeed this economic reform package was implemented in 1987 and Uganda did not see any significant increase in net inflows of foreign direct investment until 1993. (World Bank) Hence there is a six year gap where serious economic recovery wasn’t enough to entice foreign entities to invest in Uganda, despite the improvement in public debt management and the curbing of inflation. Budget Transparency & Foreign Direct Investment in Developing Countries 2011
Although, in the end of 1992 beginning of 1993 Uganda embarked on a reform scheme aimed at increasing budgetary discipline. These changes to the budget system included, enhancing fiscal discipline, enhancing efficiency and effectiveness of public expenditures, improved financial management and accountability, and finally, improving transparency and openness of the national budget processes. (Mwenda, 2005) As consistent with the OECD guide to budget transparency, the Ugandan government adopted a clearly defined system of cash accounting, overseen a realignment of policy objectives to an outcome/output orientation, undertaking clear public expenditure reviews (performance auditing), and lastly increased the scrutiny of parliament through the newly formed Parliamentary Committee on the Budget. In adopting these reforms, many of which explicitly outlined in the OECD guide to budget transparency, we can see a noticeable effect on all of our aforementioned determinants of foreign direct investment.
The Ugandan currency (shilling) has experienced stable rates of inflation, around 4.6%. (World Bank) The level of corruption in Uganda while still quite widespread is on par with that of its neighboring countries. Further, the perception of corruption in Uganda has become less and less accepted over the past decade. (Transparency International) Crucially on the topic of corruption, the International Monetary Fund and World Bank have stated that as African governments adopt reforms aimed at budget transparency and various administrative reforms would, “lead to the emergence of a smaller and more competent state, one in which there would be fewer opportunities for corrupt behavior.” (Mwenda, 2005) The dramatic budgetary reforms, along with the macroeconomic corrections, have produced stable and predictable fiscal norms, as well as fiscal decentralization within Uganda. In 1993 -just after these budgetary reforms-, Uganda began to see levels of foreign direct investment for the first time in almost twenty years.
Recently, the International Budget Partnership (UBP) has shown an increase in the level of budget transparency in Uganda. From a score of 31% on the budget transparency scale (0-100%), the Ugandan government has steadily increased its level of budget transparency to 55% as of the latest survey in 2010. According to Budget Transparency & Foreign Direct Investment in Developing Countries 2011
the IBP, Uganda publishes a comprehensive citizens budget document, publishes decent (grade of C) In-Year Reports, produces a very substantive (grade of A) Pre-Budget Statement and enacts the national budget in a clear and concise manner which has the rule of law once enacted. Since improving its budget transparency index, and putting fiscal practice in line with international best practice –as outlined by the OECD- Uganda has predictably seen a sizeable increase in net in-flows of foreign direct investment, growing from just 2% of GDP to over 7% of GDP over the last decade. (World Bank)
Conclusions and Implications:
In this essay I attempted to summarize the theoretical determinants of foreign direct investment, connect them to OECD best practices of budget transparency, and then link the two together in a clear and concise real world case study –Uganda. In summarizing the determinants of FDI, we can see that currency strength, domestic fiscal norms, level of corruption, risk of expropriation all contribute to, and are interconnected to the risk inherent in undertaking foreign direct investment. We should care about this topic because in the current fiscal climate, governments around the world are cutting expenditure making foreign aid to developing countries less and less sustainable while such economic uncertainties exist. Thus, it is important for developing economies and the governments wishing for better outcomes for their people to find alternative modes of development revenue, foreign direct investment provides such revenue. Along with increased revenue, FDI in developing economies also provides numerous positive spillovers which include, technological and managerial gains by domestic firms, increased domestic production, and increased downstream profits for domestic enterprise. However, there is some serious resource problems associated with undertaking budgeting reforms. As mentioned above, I believe that the benefits vastly outweigh the costs of undertaking such reforms. Adopting budget transparency has led to more favorable fiscal and monetary outcomes, a check on corruption, better governance, increased citizen involvement, and the subject of this essay, increased FDI. Budget transparency should be seen as a priority for developing countries. It is Budget Transparency & Foreign Direct Investment in Developing Countries 2011
not however a panacea, or a fix all for developing countries. Budget transparency can be seen however as a substantial first step towards integration into the world economy through increases in FDIs and a first step towards getting out of the resource/aid paradox for developing nations. Budget Transparency & Foreign Direct Investment in Developing Countries 2011
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