Key message 2 – Infrastructure, institutions, and incentives must be addressed to attract more FDI

Infrastructure

Reliable electricity and efficient transport systems can attract FDI

Although Africa’s infrastructure is improving, it is starting from a low base. Lack of efficient basic infrastructure such as electricity, transportation, ICT and water is a major cause of Africa’s low levels of competitiveness and productivity, along with low numbers of exporters and limited intra-regional trade (African Economic Outlook, 2014).

Electric power remains Africa’s single greatest infrastructure constraint, with low access, poor reliability and high cost as key issues. According to a recent World Bank Enterprise Survey (2011/2013), 37% of foreign manufacturing firms identified electricity as a major constraint for doing business in Africa (Chen et al., 2015). Reliability of electricity supply is a major problem. African manufacturing enterprises experience power outages 56 days per year, on average, resulting in a loss amounting to 6% of annual sales (ibid). The average effective electricity tariff in sub-Saharan Africa is high, around USD 0.13 per kWh compared to USD 0.04–0.08 per kWh in other developing countries. Transport infrastructure runs a close second in terms of constraints to FDI, especially for the onethird of African countries that are landlocked. Poor infrastructure raises the cost of inputs to manufacturing and other activities. In Rwanda, for example, transport costs from coastal ports to Kigali add roughly 50% to the cost of landed inputs.

FDI and the service sector

Efficient services are critical to economic development as inputs into the production of other services and goods. For example, a competitive financial sector is essential to mobilising domestic savings and channelling them into productive activities. Business services such as accounting and legal services reduce transaction costs associated with the operation of financial markets and the enforcement of contracts. Lastly, retail and wholesale distribution services are a vital link between producers and consumers. The rise of global value chains and trade liberalisation in Africa has further increased the importance of services in the value addition that takes place at each step along the supply chain.

FDI is a particularly important channel for international provision of services and associated transfer of knowledge and know-how, as well as a mechanism through which higher quality, lower cost services improve total factor productivity of firms that use services relatively more intensively. Telecommunication services, for example, have been shown to be vital to export growth and effective participation in supply chains. An implication is that services trade liberalisation can have positive effects because foreign services are a channel for knowledge and technology transfer. In a paper for the IGC, Hoekman and Sherpherd (2015) found that increases in services productivity were associated with increases in manufacturing productivity and, ultimately, export growth. Promoting efficient services therefore becomes crucial in harnessing the benefits from FDI and advancing industrialisation.

Equally important for attracting FDI is addressing the policies governing infrastructure. For example, restrictions on competition through cabotage1 policies, axle standards, and differing weight standards as well as licensing or border inspections all work to undermine the efficiency of road infrastructure, and increase the pressure on other forms of connectivity, such as telecommunication and air transport (see Arvis, et al., 2014). Reducing delays at the border and in transit can have a dramatic effect on reducing costs – and therefore increasing exports (ibid). On average, in 2006, it took 116 days to move an export container from the factory in Bangui, Central African Republic, to the nearest port and fulfil all the customs, administrative, and port requirements to load the cargo onto a ship (OECD, 2011). Even though the number of days has been falling in Africa, exporters and importers require 50% more time to market exports than in East Asia.2 Another issue is delays at ports and airports where, for example, closed sky arrangements can reduce the efficiency of airport facilities (Moran 2001; Chen et al., 2015).

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Image credit: Ben Welle


Institutions

Strengthening institutions like investment agencies and customs authorities are key to incentivising FDI

Too often, weak institutions stifle investment in Africa. Trade barriers include poorly performing customs services, inadequate coordination of agencies operating administration at border posts, and standards agencies that lack mutual recognition agreements with neighbours and major supplying countries. Strengthening customs authorities and establishing export promotion agencies can significantly facilitate trade and attract further FDI (Lederman et al., 2009). Moreover, well-designed and managed investment promotion agencies represent a cost-efficient way of attracting FDI – from existing as well as new foreign investors – by reducing information costs and streamlining approvals (see the IGC Enterprise Maps and related research by Sutton & Kellow, 2010).3

Lastly, underperforming educational institutions that do not generate enough high skilled workers, coupled with rigid labour markets, can deter FDI. By 2040, Africa is expected to have the world’s largest labour force, but the challenge will be to have a high enough share of skilled workers in the labour force.

Education levels remain relatively low, with sub-Saharan Africa only achieving a secondary school enrolment rate of 40%, and there is a large mismatch in skills that job seekers offer and those sought by employers (ibid). Reforms are needed to the curricula of secondary and tertiary institutions. Technical and vocational training programmes could be one way to equip African workers with the skills that businesses need (see for example IGC research by Casey et al., 2011; Martins et al., in progress; and Kingombe, 2012). Finally, employers and employees need more flexible employment rules, as labour laws in many African countries are restrictive in comparison with other regions.

Knockout factors

A pre-requisite for stimulating investment in productive activities is a reasonably robust investment climate – peace and security, macroeconomic stability, respect for property rights, and manageable levels of corruption. These “knockout factors” are so critical to a firm’s operations that their absence undermines domestic and foreign investment, especially in manufacturing. Resource-seeking FDI is generally more tolerant of a poor investment climate because the costs of enclave investments are less dependent on the broader economic and political conditions and bespoke arrangements can be agreed with local elites. For efficiency- or market-seeking FDI, however, political or economic instability may be an insurmountable obstacle to investment. The presence of corruption in government is debilitating and can effectively stifle FDI inflows, even when other aspects of the investment climate are favourable. These conditions are often deep-rooted institutional failures, politically sensitive and difficult for donor agencies to address, yet they are fundamental in attracting FDI and need immediate attention.

Incentives

Reducing policy-induced price distortions is essential to boosting exports and FDI

Policy-distorted price incentives that discourage exports also deter FDI.4 The worst culprit is overvalued exchange rates, which numerous studies have found to deter exports of manufacturing and undermine growth (Rodrik, 2008). This is less of a problem in Africa than it was two decades ago, and the introduction of floating exchange rates and inflation targeting has improved matters. But maintaining a competitive real exchange rate is crucial if Africa is to expand manufacturing exports.

While tariffs and trade restrictions in Africa have been reduced, they continue to act as disincentives to exports and FDI, and distort domestic investment, by reducing the competitiveness of manufacturing (Looi Kee et al., 2009). The rise in global value chains has increased the opportunity cost of maintaining inefficient border procedures, high tariffs, non-tariff barriers, and restrictions on the flow of information and people. As every day of delay in the movement of goods in the value chain raises the price to the final consumer, importing has to be as efficient as exporting. The need to coordinate delivery times and multiple inputs into production at a given stage mean that a wide variety of both public and private services are critical to global connectedness. Regional trade agreements that drive down trade costs while expanding markets can have a powerful effect in attracting FDI.

Experience in China and elsewhere in Asia shows that special economic zones (SEZs) can be highly effective in attracting FDI, by ensuring that the infrastructure, institutions and incentives all work to support manufacturing and facilitate trade. But with few exceptions, African SEZs have underperformed. Farole (2011) suggests that the key success factors are infrastructure and trade facilitation.

The case for price incentives or subsidies appears to be weak. In his review of African experience, Farole (2011) concludes that incentives and subsidies are not a significant factor in the success of SEZ’s. More generally, effective subsidies take many forms and can be paid for by the consumer directly (e.g., tariffs) or by government (e.g., tax incentives, reserve procurement policies, state-owned enterprise pricing, preferential loans). Harrison and Rodríguez-Clare (2010) find little evidence that countries benefit from price incentives (e.g., to deal with externalities or knowledge spillovers from FDI).

Footnotes

  • 1 Trade or transport in coastal waters or airspace, or between two points within a country.
  • 2 For example, Freund and Rocha (2010) estimate that trade volumes are 16% lower than what would be expected, and the difference is almost wholly accounted for by the added time to export.
  • 3 Harding and Javorcik (2011) find evidence from investment promotion agencies in 124 countries that shows that sectors designated as a priority for investment promotion received more than twice as much FDI as non-priority sectors.
  • 4 For example, Bende-Nabende (2002) analyses the experiences of 19 sub-Saharan African countries in 1970–2000 and finds that the most dominant long-run drivers of FDI, except market growth, are export-orientation strategy and FDI-related policy liberalisation. Recent studies, such as Lederman et al., (2010) supports the finding that trade openness is important for attracting FDI.