The Political Economy of Foreign Direct Investment: A Framework for Analyzing Investment Laws and Regulations in Developing Countries

Kofele-Kale, Ndiva, Law and Policy in International Business

Introduction

The Political Economy Paradigm

The governments of most developing countries continue to express a desire to stimulate and guide the socioeconomic development of their nations. To achieve this goal of state promoted and directed development, governments have intervened in their economies either directly, by controlling public enterprises,(1) or indirectly, by regulating the private sector through the legal system. Believing that private investments will contribute to the desired expansion of national output, these governments have resorted to a variety of schemes to induce private-sector firms, both foreign and domestic, to become more involved in the economy.(2) The role of private investment in the economic growth and development of the host countries and the impact of investment regimes on capital in-flows are issues that remain unresolved in the literature on private direct investments in Africa.(3)

Although a significant amount of empirical work has been done on the link between foreign direct investment (FDI)(4) and economic growth and development,(5) comparatively little attention has been paid to the effect that investment laws and regulations have on the amount of private capital actually invested.(6)

Studies of the legal aspects of doing business in developing countries have primarily focused on the details of the legal regimes governing foreign direct investment.(7) This approach has increased our understanding of the legal and regulatory framework within which private investors operate, yet it has failed to illustrate whether - and if so, how - the legal regime for foreign private investments has increased the capital levels in the host-country's economy or has promoted other significant governmental objectives for the economy.

Current legal writing on the regulatory environment for FDI in developing countries suffers from other deficiencies as well. In the first place, the studies on the legal aspects of doing business tend to be country-specific, and their general utility is thus somewhat limited.(8) Second, they offer little or no help toward developing a broad-gauged theory of FDI.(9) Given their emphasis on legal rules and regulations, rather than the social substructure underpinning the rules, these studies make no attempt to explore the interplay between such rules and other extraneous factors that also influence the flow of FDI. Finally, the legal environment of FDI traditionally has been studied and analyzed without consideration of the broader political economy context, ignoring the latter's influence on the former. Realistically, however, the law is inextricably interwoven with economics.(10) Therefore, the coexistence of law and the economy must be defined and described, rather than ignored because it lies outside the province of routine legal analysis.

The flaws in FDI scholarship need not detract from the important fact that policymakers in developing countries are acutely aware of the need for substantial capital formation if they are to develop into modern, technically advanced industrial societies.(11) The availability of significant amounts of capital played a prominent role in the early stages of industrialization in Europe (especially in England); the United States and Canada; the primitive "socialist" development process (for example, in the former Soviet Union); and, through the Marshall Plan, in the reconstruction of a war-ravaged Europe and Japan(12) in the late 1940s. Clearly, capital accumulation also stands to play an equally significant role in the industrialization of Africa.(13) In Africa, as elsewhere, in addition to domestic capital accumulation, development would greatly benefit from both private and public external capital inflows.(14)

Recognizing the potential benefits of FDI,(15) developing countries have enacted various kinds of investment legislation in the last two decades. The newer investment laws, together with related development legislation and assorted policy statements, have generally had as a basic objective the improvement of the environment for FDI.(16) But, as was the case in Indonesia for example,(17) most developing countries continue to approach FDI with a certain degree of ambivalence - one which is also reflected in their investment codes. For the leaders of developing countries, foreign investors have become something of a necessary evil. As early as 1967, the former President of Tanzania, Julius Nyerere, captured this sentiment when he said:

The real ideological choice is between controlling the economy

through domestic private enterprise, or doing so through some

state or other collective institution. But although this is an ideological

choice, it is extremely doubtful whether it is a practical

choice for an African nationalist. . . . He will find that the real

choice is between foreign private ownership on the one hand and

local collective ownership on the other. . . . Private investment in

Africa means overwhelming foreign investment. A capitalistic

economy means a foreign-dominated economy. These are the facts

of the African situation. The only way in which national control

of the economy can be achieved is through the economic institutions

of socialism.(18)

In 1970 President Nyerere's government issued a White Paper admonishing other African states to be wary of foreign private enterprises.(19) The official statement pointed out that foreign private

investments will not normally make the economy of the Third

World nation concerned any more self-reliant as long as the multinational

corporation retains its control. The satellite relationship

will continue to exist while questions of output, markets, technology,

research and management are determined by corporations

which are basically North American, West European, Japanese,

and South African. From all this it becomes obvious that Third

World countries need to consider very carefully the potentialities

and the dangers of multinational corporations.(20)

This position was echoed by President Suharto of Indonesia, who was equally sanguine about the perceived potentialities and dangers of foreign multinationals in his part of the Third World: "[f]oreign capital investment is indeed necessary for the development of our country. However, our identity and national interest should in future continue to be safeguarded against the presence of foreign capital."(21)

In sum, we find on one hand that governments want to court foreign investors because they can assist in the process of transferring capital and modern technology from the advanced industrial democracies while simultaneously helping the economy of the capital importing country by developing its local technical and managerial skills. On the other hand, foreign investors tend to arouse fear and suspicion in developing countries, that is, an apprehension that their economy will come under foreign control and domination. This fear, coupled with an almost instinctive Third World suspicion of and hostility toward the private sector,(22) has dulled the enthusiasm for foreign investments.

In any event, the "approach-and-avoidance" attitude toward FDI has meant that the investment laws and regulations adopted in many of these developing countries consist of what may uncharitably be described as a mismash of incentives and disincentives, which are often internally inconsistent. To the extent that this is an accurate portrayal, legal scholars are faced with the challenge of devising a legal, regulatory, and economic-policy environment which is favorable to FDI and yet sensitive to the host countries' well-founded fears of giant multinational corporations.(23) At the outset, legal scholarship must begin to address the need for more sustained empirical investigations on the determinants of FDI. Such a body of knowledge is needed to further the task of systematization and FDI theory formulation.

It is necessary to begin by supplementing the legal positivist approach that dominates the current scholarship on the legal environment for FDI in developing countries and attempts to study investment laws and policies in isolation from the political economy context. By ignoring the political economy context, this genre of legal scholarship overlooks the very questions that require rigorous analysis. The preoccupation with the rules and regulations governing foreign investment is inadequate, yielding little ability to predict the utility of a proposed set of regulations in the developing country context. Additionally, this preoccupation with legalism also proceeds from certain unstated assumptions about the nature of the state and the legal system that emanates from it. The assumption that states are somehow "rational, self-conscious, self-determining units" analogous to the economic man is implicit in these descriptive studies.(24) It is further assumed that the definitional characteristics of each state will be reproduced in its legal institutions.

Such assumptions implicate some fundamental, but unresolved questions in the debate over the nature of the state in postcolonial developing societies:(25) the control of the state apparatus in developing countries; the extent of an effective class basis of the state; the degree to which the state serves the interests of the dominant class; the composition of the dominant class; the state's ability to create an environment favorable to FDI independent of the dominant class interests; the extent to which laws and policies regarding FDI reflect the particular values, economic interests, and power advantages enjoyed by the dominant class in society; and the potential for the manipulation of the environment for FDI.(26) These questions cannot be addressed adequately in studies that merely map the legal regulatory structure of FDI.

A textual analysis of rules and regulations reveals little about their social effects or ability to solve pressing social and economic problems. Moreover, the emphasis on forms and structures illustrates little about the normative context in which laws are formulated and exercised. Rather, it is the way in which such forms are employed and manipulated that is significant.(27) This is particularly true for developing countries, with their borrowed legal values and institutions, many of which have yet to be completely integrated into the indigenous sociocultural fabric. In developing countries, legislative formulations on FDI(28) may actually mask their true purposes, while legal rules and regulations may not truly reflect practice.(29)

The legal environment for FDI in developing countries, therefore, must be studied within the broader context of the social and economic environment. The influences and constraints of both the domestic and global economies on the environment for FDI are crucial to an understanding of this phenomenon. Such an approach, which explicitly recognizes that there are a multitude of factors that influence the legal environment for FDI, is referred to herein as the political economy context of FDI. Such factors include natural resources, cultural characteristics (including labor relations and the work ethic), location, colonial relationships, infrastructure, education, skill levels, political orientation, trade-treaty relationships (including Lome status and Commonwealth status), and government efficiency.

The legal system is not autonomous, nor are the rules and regulations that it devises neutrally applied; laws are designed to promote and protect certain interests in society. Any analysis of state intervention must also incorporate the external environment:

The manner in which the process of production is organised, the

ownership of the means of production, the mode of the distribution

of the products, the way in which society is stratified, [and]

the relations between the modern and the traditional sectors of the

economy determine very significantly the role and operation of the

law and its institutions.(30)

It is only after these interests have been identified that one can begin to understand the operation of the law or to predict future outcomes. In sum, the legal regime for FDI cannot be understood without first analyzing its socioeconomic origins because, in the architectural imagery of traditional Marxism, the superstructure of legal institutions rests on the substructure of economic relations.(31)

The framework within which research on the legal regime for FDI in the developing world is conducted must incorporate the external environment. The investment regime, like public enterprise, is capable of multiple uses that are determined by such factors as the mode and relations of production, the nature and alliances of the ruling classes, and the access to and control of the state apparatus. Ultimately, the success or failure of the investment code will depend on the nature of the state. For a realistic understanding of the constraints on the development of legal institutions, research on state intervention in the economy through regulatory means must also focus on the state itself - its nature, its functionaries, and its controlling elements.

Such a focus is particularly appropriate for postcolonial Africa, where an understanding of the role and mechanisms of the state is still inchoate. The state is always involved in the economy.(32) However, its decision to use the device of regulation to intervene in the economy to encourage foreign private investment, as opposed to alternative modes of intervention, is of particular interest. The state is not an abstract or neutral entity, but is instead a politico-economic apparatus manipulated by certain groups in society. "[I]t encourages, promotes or induces certain forms of growth, favouring particular groups or classes."(33) Finally, state investment laws and policies may be used to enhance certain groups, while hindering others. It is important to examine whether investment laws and policies aimed at involving foreign investors in the private sector also operate as catalysts for class formation.

Consequently, this Article empirically examines the relationship between FDI and host country investment laws and policies, utilizing transnational quantitative data for three African countries. Section 1 briefly reviews the theoretical explanations for the migration of capital from the advanced industrialized nations to the developing regions of the world. In Section 2, attention shifts to the theoretical arguments in support of state intervention in promoting capital accumulation in capitalist economies. This review necessarily leads the discussion to the various theories of the state. This theoretical exploration helps define the context for the subsequent examination of the nature of the state in postcolonial "peripheral" and "semiperipheral" capitalist societies,(34) the state's structural basis, and its operational independence from the constraints imposed on it by a world capitalist system. The relative degree of autonomy the postcolonial state apparatus enjoys from internal and external forces and interests is central to this analysis. Section 3 introduces a conceptual framework for testing the hypothesis that the flow of FDI to developing countries increases in response to the generosity of the host country's investment policies. After conceptually significant determinants of FDI are derived, the relationship between FDI flows and state investment policies is examined through a time-series multiple regression. Here, pooled time-series, cross-section equations are estimated, relating FDI flows to a number of economic variables for the entire sample period and for the period before investment laws were liberalized (roughly 1960-1984), as well as for more recent years (1985-1990).

I. Foreign Direct Investment and Developing Countries

In the 1960s, foreign direct investment(35) and official foreign aid constituted the most important capital flows to the Third World.(36) FDI to developing countries during this period accounted for twenty-five percent of all foreign capital flows to developing countries.(37) By the 1970s, however, external capital flows to developing countries largely took the form of medium- and short-term bank credits, rather than FDI or portfolio equity investment.(38) As a consequence, FDI as a proportion of total foreign capital flows fell to about ten percent.(39) More recently, there has been renewed interest in FDI as a source of capital, which is occurring against the background of an actual decline in the share of FDI in the aggregate flow of external resources to developing countries.(40) For instance, net FDI in the Third World fell from approximately fifteen billion dollars in 1981 to about ten billion dollars in 1983 and has remained at about that level ever since.(41)

Given the importance developing countries attach to FDI, its declining relative importance in the aggregate of financial resource flows is a cause for concern. At best, this decline suggests that competition among developing countries for increasingly scarce FDI is likely to intensify. The question that naturally arises in this context is the effect of state investment policies on the flow of FDI to host developing countries. However, this question has no obvious answer.

For example, if FDI is viewed as the movement of a bundle of capital plus technological and management "know-how"(42) from a private firm in the United States or Japan to its foreign subsidiary in Cameroon, those factors attracting investment by private firms in such an environment must be analyzed. Several theories have emerged in response to this question of what attracts investment, although no one predominates.

Classical economic theory views FDI as a strategy by which oligopolistic multinational corporations seek to close out market competition by erecting barriers to entry related to firm-specific advantages such as superior knowledge, product differentiation, and access to credit.(43) A competing view sees FDI as resulting from various internalizing economic activities pursued by multinationals to minimize transaction costs in order to provide more efficient outcomes than the market.(44) It is of some interest to note that while both perspectives emphasize the interplay of market forces, they completely ignore any role the host government might play in inducing FDI into its borders. This implicates the question of whether host country investment laws and policies aimed at attracting and maintaining a steady flow of FDI have any relevance in the theory of FDI migration from the advanced industrial countries to the developing countries.(45) Only recently has scholarship on FDI in the developing world begun to acknowledge the dearth of attention paid to the potential influence of host government policies upon the flow of FDI.(46)

II. State Intervention and Capital Formation

The Role of the State in a Capitalist Economy

It is generally agreed that the active intervention of the state in the economy to promote capital accumulation or encourage distribution is an integral part of any successful capitalist development program and remains a key factor in the industrialization process.(47) "In advanced industrial countries and in the |semi-periphery,' growing state activities and an increasingly deep penetration of economy and society by state interventions seem to have played a critical part in enabling capitalist political economies to foster economic growth and manage socioeconomic conflicts."(48)

More generally, the state can intervene in the economy in one of two ways. The first alternative is the public enterprise model, where the state actually enters into production in order to directly manage the economy.(49) The other main approach is the regulatory model, where the state itself does not take over sectors of the economy, but seeks to influence the conduct of private economic actors through a variety of regulatory or other mechanisms.(50) However, these models do not exist in isolation; rather "they exist side by side, sometimes reinforcing each other, and sometimes in some degree of confusion, if not actually in antagonism."(51) These two models of state …

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Publication information: Article title: The Political Economy of Foreign Direct Investment: A Framework for Analyzing Investment Laws and Regulations in Developing Countries. Contributors: Kofele-Kale, Ndiva - Author. Journal title: Law and Policy in International Business. Volume: 23. Issue: 2-3 Publication date: Spring 1992. Page number: 619+. © Georgetown University Law Center Fall 1997. COPYRIGHT 1992 Gale Group.

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