Columns - The Sunday Times Economic Analysis

The importance of Foreign Direct Investment

By Nimal Sanderatne

There is a strong relationship between foreign investment and economic growth. Larger inflows of foreign investments are needed for the country to achieve a sustainable high trajectory of economic growth. There are several irrefutable reasons for this. For the economy to grow by 7 to 8 per cent a year there is a need to invest around 35 to 40 per cent of GDP. National savings fall far short of this by nearly 10 per cent. Foreign borrowing and foreign investments have to meet this investment-savings gap. This is generally recognized and successive governments have attempted to provide various incentives to foreign investors. However the Sri Lankan record of foreign investment has been far below expected levels and low in comparison with many other Asian countries.

Now that there is peace and security, the biggest hindrance for attracting foreign investments has been removed. Therefore higher amounts of foreign direct investments are expected. Will this be realized? Peace and security are necessary conditions, but not sufficient conditions to attract foreign investment. This is clear from the fact that foreign direct investment (FDI) has been below expectations in 2010. What are the reasons for the sluggish inflow of FDI?

What are the other conditions that must be fulfilled to attract FDI? There are many conditions that have to be put in place to attract FDI. It is important to ensure an attractive investment climate. Consistent macroeconomic policies, good governance, economic stability, guarantee of property rights, rule of law and absence of corruption are among the conditions required to attract FDI. Consistency and predictability in economic policies and political stability are preconditions to attract FDI.


Foreign investment comes in several forms. Portfolio investment, foreign loans and foreign direct investment are the three important types. Of these foreign direct investments in industry and services are the most useful. Foreign loans are generally used for investment in infrastructure. This is important as a serious bottleneck for domestic as well as foreign investment is the poor state of infrastructure. However the development of infrastructure alone would not suffice.

The significance of private FDI is that such investments are risk free to the country and bring with it the advantages of advanced technology, management practices and assured markets. In due course there is a technology transfer as the local workforce gains knowledge of the manufacturing processes and management practices. The value added in these industries is a contribution to GDP and foreign exchange earnings. Therefore FDI contributes to foreign exchange earnings, employment creation and increases in incomes, especially of skilled and semi-skilled workers in these industries.

Early setback to foreign investment

The country missed many opportunities to attract foreign investments in industry owing to the ethnic conflict. Dr Saman Kelegama has pointed out that: “1983 was a turning point in regard to missing big international investors and all hopes of becoming the new investment centre of Asia faded away. He contends that in the mid-1980s Sri Lanka missed the chance of attracting some portion of the Japanese surplus due to the war related uncertain political climate.” He contends that “The South East Asian economies really made a kick-start from this recycling surplus during the mid-1980s”.

Kelegama has pointed out very specifically the impact of the war on foreign investment. “The uncertainty created by the war was the main deterrent to foreign investment -- which acted as a catalyst to the growth process. Some examples would suffice to indicate the missed opportunities. Two major electronic multinational companies - Motorola and Harris Corporation - had finalized plans to establish plants in the Export Processing Zone prior to the change in the political climate in 1983. Harris Corporation even started building a plant with an initial employment capacity of 1850 workers. Both these companies withdrew from Sri Lanka after the 1983 ethnic riots. Motorola shifted to Malaysia and Harris Corporation went elsewhere leaving a half-built plant in Sri Lanka.

Besides these two Corporations, Marubeni, Sony, Sanyo, Bank of Tokyo and Chase Manhattan Bank, were in the pipeline to invest in Sri Lanka in the early 1980s. All these big Companies decided against investing in Sri Lanka after 1983. Sri Lanka lost a major opportunity of taking a big leap forward because, if these investments had materialized, they would have given a strong signal to other large multinational companies to start industries in Sri Lanka.”

There can be little doubt that the security situation was the single most important factor in the country being unable to attract substantial foreign direct investment. Tax concessions, financial incentives and assurances hardly offset this drawback of insecurity. The fact that the Japanese, the highest aid givers and an important trading partner, are not large investors in Sri Lanka is a telling example, as it is counter to the usual practice of aid, trade and investment moving in tandem. This lost opportunity has been very costly as it is much more difficult to attract FDI today when a large number of countries are offering attractive incentives.

Prospects and preconditions

There is not much point in crying over spilt milk. What is needed is the correct environment to attract investment in a global context when even developed countries are vying for foreign investment. Sri Lanka needs to develop the physical and technological infrastructure, enhance its human capital and improve its labour market conditions and administrative capabilities to induce higher levels of foreign investment. There has been progress in the development of infrastructure. The road network has been improved though urban traffic congestion remains a problem. The power situation is much better though electricity tariffs are high. Skills development leaves much scope for development.

Labour legislation is considered a serious disincentive. It is unlikely that the government would formulate the necessary labour reforms to allow for flexibility in the recruitment and discontinuance of workers. This may continue to be a disincentive for FDI as other countries are far more flexible in their labour laws allowing workers to be discontinued when business conditions necessitate a reduction in labour force.
Despite peace and political stability foreign direct investment has not increased.

There is an expectation that FDI would reach US$ 1000 million this year. Although this is a doubling of last year’s FDI, it is inadequate. Besides the quantum of FDI, the types of FDI also matter. There are foreign investments in the hospitality trade but little in industry and manufactures, investments in manufactures are especially needed. To attract such investment it is essential to ensure an attractive investment climate. Consistent macroeconomic stability, guarantee of property rights, rule of law and absence of corruption are among the conditions required to attract FDI. Recent events have tarnished the country’s political image and foreign perceptions of the country. These non-economic factors too have an influence on FDI.

Wrapping up

While the end of the civil war led to expectations of much higher FDI, this has not been realized. The only substantial FDIs have been in the hospitality trade. What is needed is not merely an increase in FDI but also investment in key areas of manufacture. Consistent macroeconomic policies, good governance, consistent market friendly policies, healthy economic indicators, guarantee of property rights and the rule of law are required to attract higher levels of FDI.

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