Intra Regional FDI Flows in South Asia : Current Status and Future Prospects

Aradhna aggarwal Associate Professor, University of Delhi Consultant , ICRIER March 28-29, 2007

Objectives
The objectives of the study are to examine emerging trends in regional cooperation in South Asia and analyse, in that context, the magnitude of intra and inter (extra)-regional FDI flows, the main source countries and the major sectors that have attracted FDI in the region;

the future prospects of FDI flows to the region; and challenges faced by these countries in increasing their attractiveness to foreign investors.

The Presentation
Background and scope of the study (Evolution of Regionalism) Regional Integration and FDI : A Theoretical Approach Regional Cooperation in South Asia Investment Flows in South Asia: The Current Status Prospects for FDI in South Asia : The Role of Regionalism Challenges Conclusions

Evolution of Regionalism
A proliferation of formal economic cooperation and economic arrangements aimed at facilitating and enhancing economic integration at the regional level. It is referred to as regionalism The most. prominent form of regionalism remains the regional trade agreement (RTA). In 1990, : only about 40 agreements in force Feb. 2005 : 260 RTAs had been notified to the GATT/WTO of which over 170 RTAs were in force Traditionally, RTAs aim at stimulating trade and cover only trade barriers( Old regionalism) Now RTAs are more comprehensive. Three components of RTAs. The need to attract investment is increasingly cited as an impetus to RTAs. ( New regionalism) Regionalism also takes the form of International investment agreements : BITs, DTTs and PTIAs Most studies however focus only on trade effects of regionalism. Emerging literature. This study examines investment flows in the SAARC region comprising south Asian countries.

Regionalism in South Asia: Trade Agreements

SAPTA : 1995. SAFTA : 2006. Under the agreement, all non-LDC members would reduce their existing tariffs to 20% within a time frame of two years from the date of coming into force of the Agreement. In addition to SAFTA, there have been 5 intra/inter-regional free trade agreements : India- Bhutan, India-Sri Lanka (FTA), Pakistan-Sri Lanka and BIMSTEC (Bangladesh, Bhutan, India, Myanmar, Nepal, Sri Lanka and Thailand) and APTA (India, Bangladesh, Sri Lanka, Philippines China, Lao PDR and Korea). There are 7 partial free trade agreements : India-Nepal, India-Bangladesh, IndiaMaldives, Bangladesh-Nepal, Bangladesh-Pakistan, Pakistan-Nepal and Sri LankaNepal. All except BIMSTEC are traditional RTAs

Regionalism in South Asia : Investment Agreements

A Regional Agreement on Promotion and Protection of Investment within the SAARC Region has been under consideration for a long time. Bilateral Investment Agreements (BITs) are not common. No. of BITs in which South Asian countries involved: 109, No. of BITs within the region : 4. Other forms of co-operations: The SAARC Chamber of Commerce and Industry (SCCI) SAARC Trade Fairs SAARC Finance SAARC Development Fund ( Under consideration)

Regional integration can at best be described as shallow, representing old regionalism. Does not rule out the possibility of I effects.

Regionalism and FDI : The Theoretical Framework

A RTA could influence investment flows both between its constituent member countries, and from outside the RTA, in three ways: Trade effects: Within its constituent members (intra regional FDI) : Stimulating effect if FDI is vertically integrated/efficiency seeking /export oriented. Dampening effects if it is domestic market seeking FDI. From outside the RTA: stimulating effects by increasing the size of the potential markets and by raising the fear for future protection. Thus, a positive trade impact of such measures on an extra regional FDI, but an ambiguous effect on intra regional FDI. Additional Arguments for favourable impact of trade liberalisation on intra regional I :
Can shift FDI patterns from horizontal to vertical FDI in member countries, resulting in an increase in the former at the expense of the latter. Domestic market seeking investment may not be adversely affected.

However, the increase in investment may be distributed highly unevenly. Investment is expected to cluster to those members of RTAs where locational advantages are favourable.

Contd
Effects of Investment provisions: The lowering of investment barriers may promote intra-regional FDI, offsetting the negative trade effects of RTAs. Effects of other forms of cooperation: favourable Dynamic effects: RTAs may increase the attractiveness of the region by promoting economic growth and intensifying competition among member countries for attracting investment. The presence of FDI may catalyze the growth of the economy and contribute further to the growth of FDI . FDI by some countries in a country motivate the others to enter the country. The herding effect may also have favourable impact on overall investment. Overall effects : The overall effects are more likely to be positive. Empirically, there seems to be a general agreement that RTAs generate FDI stimulating effects but the degree of success varies across RTAs.

Net inflows of FDI into SAARC countries in selected years : 19802005 ( less than 1% of world FDI inflows over 2001-05

1990-2000 Bangladesh Bhutan India Nepal Pakistan Sri Lanka Maldives South Asia Asia Developing countries World 190 (2.5) 2 (0.1) 1705(3.0) 11(0.6) 463 (7.2) 159 (5.6) 9 (7.6) 2539(2.3) 76616(8.0) 134670(8.9) 495391(7.6)

2003 350 (2.9) 1.06 (0.3) 4585(3.4) 14.78(1.3) 534 (4.2) 228.72(5.7) 14(7.2) 5727.56(3.5) 110489(7.7) 175138(9.3) 557869(7.3)

2004 460.43 (3.4) 1 (0.1) 5474(3.1) .. 1118(7.5) 233 (4.7) 15(5.4) 7301.43(3.4) 157328(9.4) 275032(10.7) 710755(7.7)

2005 692 (4.9) 1 (0.2) 6598(3.5) 5 (0.4) 2183(13.0) 272 (5.2) 14(4.8) 9765 (4.3) 199951(11.1) 334285(12.8) 916277(9.4)

Note : Parentheses show the ratio of FDI to gross capital formation Source : UNCTAD 2006

Table 4: Share of Individual Countries in SAARC FDI Inflows in Selected Years ( 1990-2005)

1990-2000 Share in South Asias FDI inflows : Bangladesh 7.48 Bhutan India Nepal 0.43 Pakistan Sri Lanka Maldives Share of South Asia in: Asia Developing countries 1.89 World 0.51 3.31 18.24 6.26 0.35 0.08 67.15

2003

2004

2005

6.11 0.02 80.05

6.31 0.01 74.97

7.09 0.01 67.57

0.26 9.32 3.99 0.24 15.31 3.19 0.21

0.05 22.36 2.79 0.14

5.18 3.27 1.03

4.64 2.65 1.03

4.88 2.92 1.07

Trends in FDI outflows from South Asia

1990-2000 Bangladesh Bhutan India Nepal Pakistan Sri Lanka Maldives South Asia Share of India in South Asia (%) 87.68 Share of South Asia in Asia (%) 0.37 Share of Asia in Developing countries 66.0 Share of Developing countries in world (%) 6.3 13.9 15.1 11.8 53.4 74.0 71.2 7.25 2.51 1.74 96.22 96.75 93.68 4 Nil 121 Nil 5 7 1 124 2003 6 Nil 1325 Nil 19 27 Nil 1378 2004 6 Nil 2024 Nil 56 6 Nil 2092 2005 10 Nil 1364 Nil 44 38 Nil 1456

Share of 5 top investors in Individual South Asian Countries (%)

India US EU UK Netherlands Germany Norway Japan UAE Mauritius Singapore South Korea Hong kong Vir. islands China India 114 Total investing countries 35.6 1.8 7.5 11.4 22.7 7.0 5.9

Bangladesh (2004) 9.24 18.0 16.26

Pakistan (2003-5) 27.78 19.36 12.60

Nepal (upto 2005-06) 15.78

Sri Lanka (1979-00)

13.9

26.59

1.25

1.73 3.71

2.88 12.35 3.91

12.1

16.5 9.13 4.92 4.49 10.52 40.71 30 35 (excl. unspecified countries) 50 NA 11.5 10

Table 7 : Intra Regional FDI Inflows (% of country total)

Host country India (2005-06) Neg .0006 .01 .0002 Bangladesh (2004) 1.0 0.68 0.77 Pakistan (20035) .01 Nepal (2005-06) 40.71 0.75 0.47 0.13 .01 Bhutan ONE*

India Bangladesh Pakistan Nepal Sri Lanka Bhutan

able 9 : Share of top 5 investors in South Asia since 2002 ( No. of projects)
Sri Lanka India US UK Germany Japan France Malaysia China UAE Total 54 3 (4%) 12(9%) 18(13%) 1500 51 3051 19 (40%) 8 (17%) 3(6%) 2(6%) 9(6%) Pakistan 9 (6%) 26(18%) Bangladesh 14 (27%) 8 (16%) 4 (8%) 7 (14%) 1267 (46%) 300(11%) 195(7%) 142 (5%) 102(4%) India

Intra-Regional Investment
In Pakistan: Indian companies are allowed to invest in Pakistan recently. TCS, Dabur, VSNL, Reliance are some of the companies taking initiatives. Indian investment is into : Bangladesh: India I : Services, Chemicals and Fabricated metals and light eng. While Pakistan Co. invested in non metallic sector and food and beverages. Nepal : Indian joint ventures are in practically every sector, including tourism, infrastructure, consumer durables & non-durables and export oriented industries like garments and carpets. A number of Indian companies, including Dabur, Hindustan Lever, Colgate, etc., have established their manufacturing base in Nepal Sri Lanka: The principal sectors which have attracted Indian investment are steel, cement, rubber products, tourism, computer software, IT-training and other professional services. During the past three years, leading Indian companies such as Gujarat Ambuja, Asian Paints and Larsen and Toubro have committed substantial investments, while existing companies -CEAT and Taj Hotels, for example -have expanded their operations . Of the total equity invested by Indian companies in regional joint ventures, 54% are located in Sri Lanka. There is huge potential not only for large companies but also for SMEs if investment is facilitated within the region.

Future Prospects
Macro dynamism : High growth prospects,Industrial dynamism and emergence of the service sector Regional cooperation : SAFTA replaced SAPA, New RTAs proposed. Multilateral liberalisation

Macro economic dynamics of South Asian Economies

India

Bangladesh

Nepal

Pakistan

Sri L a n k a

Bhutan

Maldives

Total

PPP GDP (2005-6) GDP $ mn (2005-6) Population

3787 785 1049.5

296 60 143.8

42 7.3 24.6

366 107.3 149.9

89 23.48 18.9

2.9 .84 2.2

1.25 .82 0.339

4580 983.1 1389.2

Median Age (yrs) Population growth rate 2004-20 GDP growth rate Export Imports

24.4 1.3

21.5 1.6

19.9 1.8

19.4 2.1

29.1 1

20.2 2.1

17.5 2.7

21.7 1.8

8.1 25 34.4

6.2 17.2 15.3

2.8 10.3 15.7

7.6 14.7 30

5.8 10.3 13.3

7 39.3 28.8

9 17 24

6.6 19.1 23.1

Regionalism: How can deeper forms of regionalism promote FDI inflows?

SAFTA replaced SAPA, New RTAs proposed. Lowering of tariff and non tariff barriers Inclusion of Services Inclusion of investment provisions Other forms of cooperation

Lowering of trade and non trade barriers:Intra regional I

There is general pessimism regarding the effects of SAFTA on trade and investment. Many argue that intra-regional trade a small fraction (4.5%) of total trade of the region even after considerable liberalisation (The intra-EU trade is 55 percent, intraNAFTA trade stands at 61 percent and intra-ASEAN trade is 25 percent of its total trade) because these countries share some basic similarities which reduce the potential for comparative advantage driven trade. These similarities will discourage trade generated FDI effects as well. But the problem in SAARC region seems to be more political than economic . Taneja shows that there has been a considerable amount of "informal" trade among member countries of the region. This was not only to evade the high tariffs that must be paid on official trade, but also to carry out some trade that would not have been permitted at all. Mohanty identifies more than 1500 products as potential items for trade in the region and the region is capable of absorbing them. Yet the trade flows remain low.

Are the prospects insignificant due to similarities in the structure of the economies
Rank Competitiveness index

rank

basic requ irem ent

efficiency enhan cers

innovativ en ess

GCI score index

basic requirem ent

efficiency enhancers

Innovativ en ess

PCY

Adult litera cy rate (%)

India Srilanka Pakistan Banglades h Nepal Bhutan Maldives C.V. -

43 79 91 99 110 30.5

60 80 93 96 106 21.5

41 79 91 108 117 37.3

26 67 60 104 111

58.6 41.4 35.0 29.0 23.0 -

57.3 49.2 41.8 40.7 33.6 20.3

52.9 32.5 24.7 16.2 11.7 58.9

61.9 32.4 34.2 15.0 11.8 64.2

748.42 1242.3 738.7 416.95 298.62 861 2367

61.3 97.2 41.5 41.1 44 47 92.6

54.0

36.6

Source: GCR, 2006 and WDI

Composition of Export baskets of South Asian Countries at two digit level: 2004
India Textiles Stone Chemicals 21.5 17.2 10.6 Nepal Textiles metals Fats Oils and 50.6 10.2 9.3 Pakistan Textiles Vegetab les Leather 68.9 7.3 5.8 Sri Lanka Textiles Vegetables Plastic 86 17 6.5 Bangladesh Textile s Anima l Leathe r 85.8 5.6 3 Maldives Anima l Textile s Foodst uff 55.4 32 12.3

Minerals Metals Mechanical Vegetables Plastics Vehicles

9.1 9 7 6.4 3.2 3.1

Chemicals Vegetables foodstuffs Plastics

6.6 6 5.5 2.9

Vehicles Furnitur e Mineral s

3 2.8 2.8

stone Mechanical Metal

4.7 3.2 3

This implies
that countries vary widely in the quality and capacity of their scientific and technical infrastructures and business sophistication. They are pursuing similar macro economic policies but are differentiated in terms of sophistication of economic activities and innovativeness. This in turn means that there are possibilities of vertically integrated intra regional FDI. Theoretically, vertical FDI can also occur in South-South RTAs if there are sufficiently large differences between the members in incomes and other determinants of factor prices. Since domestic market seeking I is negligible, replacement effect is almost nil. India-Sri Lanka FTA and Investment

Extra-regional: Size advantage of combined markets

India Bangladesh Nepal Pakistan Sri La nk a GNI ($ bn) PPP GNI GDP $bn 793 3787 785,468 66.2 296 59,958 7.3 42 7346 107.3 366 110732 22.8 89 23479 0.799 0.787 4580 986.9
998.186

Bhutan

Maldives

Total

GDP growth rate

8.5

5.4

7.8

5.3

Population

1049.5

143.8

24.6

149.9

18.9

2.2

.339

1470

Population growth rate (%) 2004-20

1.3

1.6

1.8

2.1

1.0

Extra-regional Efficiency seeking FDI

Though the theoretical literature has not considered the impact of lowering of trade barriers on inter-regional FDI inflows, one can argue that due to proximity, outsiders can also exploit the locational advantages by setting up different processes across different countries within the region. This will promote efficiency seeking investment from outside the RTA also.

Inclusion of Investment provisions

Lowering of I barriers for firms from member countries may have positive impact not only on efficiency seeking intra regional FDI but also on intra regional domestic market seeking FDI flows. There are many SMEs or even large enterprises from developing countries that look for investment opportunities in not so sophisticated markets in small neighbouring countries. Lowering of investment barriers can provide an impetus to such investment. Until mid-April 2002, around 50% of foreign enterprises have been registered as SME enterprises. A large number of such companies were from India. There are larger benefits from FDI from developing countries in terms of employment, technology spillovers and learning due to the use of labour intensive medium technologies as in Nepal. This will also upgrade the capabilities of Regional firms (Investment Development Path : Dunning

Inclusion of Services
Rapid expansion of services in all these economies. While Pakistan and Sri Lanka have advantages in transport and tourism, Maldives has advantage in Travel and tourism. India has advantage in IT and IT enabled services. Thus there is a scope for regional cooperation and FDI in services. Most services are non tradables and require commercial presence of the service providers. Inclusion of services therefore is expected to promote FDI in services. Inclusion of services in RTAs will also facilitate the cross border movement of people. A substantial portion of Indian FDI in neighbouring countries has been in the service sector .

Promoting other forms of Cooperation

Trade facilitation : harmonisation of trade documentation and rules; unhindered movement of goods, better connectivity, mutual recognition of standards through accredited testing laboratories. Joint project for the development of infrastructure and power. Freer movement of natural persons across borders Deeper cooperation between business chambers.

Multilateral liberalisation
Economic Reforms since 1990s. FDI: Pre-entry policy space in all the countries but post entry national treatment. Wall Street index of barriers in 2000 for South was 3 on the scale of 1-5 which was the same as the raking for other developing countries. Since then, the FDI regimes have further liberalised. Of all the South Asian Countries, Pakistan follows the most liberal FDI policies followed by Bangladesh, Nepal, India, Sri Lanka, Maldives and Bhutan in that order.

Future Prospects of FDI Flows

Most South Asian initiated economic reforms in the 1990s and liberalised FDI policies substantially. Although their share in global FDI inflows increased gradually, it still remains very low. Further, intra regional flows have been abysmally small. Apparently, macro economic reforms and liberalisation of FDI alone did not yield substantial benefits. And, the countries could not exploit the potential of regionalism in promoting inter and intra- regional FDI inflows due to shallow integration. We propose that if the regional initiatives allow for "deeper" forms of integration, synergies generated will promote FDI inflows into the region. Future prospects are directly related with regional cooperation.

Priority sectors
These are emerging economies. The process of industrial diversification is at different stages in different countries. Thus there are several sectors which are identified as priority sectors and where FDI can be promoted. Bhutan : Agro Based processing, finance, Travel and tourism, hydro electrical power, IT Nepal : travel and tourism, Hotels and restaurants, IT. Keen on investment in infrastructure, hydropower and roads. Pakistan : Financial, IT, Gas and oil explorations, trade construction and power. Bangladesh: Textile, services, agro based, chemicals, glass& ceramic India : Infrastructure, Power, telecommunication, Engineering, services (IT), electronics and electrical equipment and computers. Sri Lanka : Textiles, Pharmaceuticals, Auto, Software, Gems and Jewellery, light engineering, electronics.

Requirement of less advanced technologies/ more labour intensive technologies, cultural affinity may be vital in determining FDI flows.

Challenges
The major challenge is to improve investment climate in the region. This will promote not only intra-regional I but also inter-regional I. Further, intra regional I will itself result into investment from outsiders due to herding effects and efficiency effects. The following bottlenecks need to be addressed Political factors:
Political mistrust Psyche to look to the west Administrative barriers Complex trade and custom rules Corruption Poor trade and production infrastructure Poor connectivity between countries

Domestic barriers:

Cluster and SEZ approach can play a vital role.

Governance (IFC surveys)

Average time spent with tax official s Time spent in government regulations Official predictability Unofficial payments Bribes to Tax official s Bribes to secure contrac t

East Asia & Pacific Europe & Central Asia

4.91 2.82

7.25 5.4

51.86 45.13

1.81 1.04

33.59 44.79

1.82 1.57

Latin America & Caribbean

2.75

10.39

40.11

1.52

6.83

2.94

Middle East & North Africa

3.52

9.94

50.87

2.72

40.09

1.3

OECD South Asia Sub-Saharan Africa

1.65 3.19 4.41

2.97 7.1 8.55

57.52 61.52 48.97

0.13 2.02 1.94

28.26 46.94 20.74

0.55 3.32 4.04

Infrastructure

Delays in electrical connection

No.of electrical outage

Value lost due to electrical outage

No.

of water supply failure

Delays in telephone connections

East Asia & Pacific

12.02

7.04

2.39

1.86

9.32

Europe & Central Asia

7.4

11.65

10.33

Latin America & Caribbean

26.49

14.91

3.26

9.06

37.47

Middle East & North Africa

43.84

44.27

4.69

34.54

51.46

OECD South Asia Sub-Saharan Africa

8.32 48.18 38.12

1.14 109.2 51.96

2.25 5.56 4.78

0.18 7.57 29.82

7.91 53.85 51.39

Trade Rules
Average export clearance time Longest export clear time Average time to claim imports from customs Longest time to claim imports from customs

East Asia & Pacific

3.71

5.98

4.89

8.98

Europe & Central Asia

2.91

5.4

3.51

25

Latin America & Caribbean

4.79

9.16

7.22

14.72

Middle East & North Africa

5.14

9.43

10.3

21.29

OECD South Asia Sub-Saharan Africa

4.63 7.72 4.45

8.33 12.66 8.69

5.28 10.08 7.37

9.4 17.54 14.55

Legal system
Confidence level in the legal system

East Asia & Pacific

65.83

8.66

56.63

Europe & Central Asia

55.18

12.59

30.92

Latin America & Caribbean

55.48

7.66

78.06

Middle East & North Africa

66.63

31.59

76.94

OECD

73.6

14.82

60.49

South Asia

53.72

12.29

93.06

Sub-Saharan Africa

60.42

10.33

83.43

Other factors
Political instability, Law and order, Visa rules, trade unionism (affiliation with political parties)