Given that production in developing countries involves lower units of capital per unit of labour relative to developed countries, the theory of diminishing marginal returns predicts
Classical economists argue that allocation of factors of production follows the theory of diminishing marginal returns. According to this theory, additional units of capital earn higher returns when employed in production processes characterised by lower units of capital per unit of labour. As a theory, it was developed in the 17th Century by David Ricardo and it should work, ceteris paribus. In practice, however, it does not.
This theory’s failure is most pronounced in global capital markets. Given that production in developing countries involves lower units of capital per unit of labour relative to developed countries, the theory of diminishing marginal returns predicts that returns to capital should be higher in developing countries. In response, capital should be flowing from developed markets to developing markets. But this is not the case.
According to the 2017 World Investment Report published by the United Nations Conference on Trade and Development, more foreign investment capital flows to developed markets relative to developing markets. In 2000, a total of $5.8 trillion in foreign capital flew to developed markets, $4 trillion more than what flew to developing markets.
Fast forward, this gap has widened. In 2017, a total of $17 trillion flew to developed markets, $8 trillion more than what flew to developing markets. Clearly, there is more to the flow of capital than what Ricardo anticipated. For developing markets, attracting the much needed foreign investment capital requires a rethink of their capital mobilisation approach. To understand this better, we need an illustration.
Uganda is a developing country in East Africa that has not succeeded in its efforts to be sub-Sahara Sahara’s most preferred FDI destination. Despite having one of the lowest units of capital per unit of labour, and a slew of incentives to foreign investors – like open ended tax exemptions – the country’s stock of FDIs has declined by 40 per over the last six years.
In 2016, the country attracted $541 million in foreign capital - a paltry 0.6 per cent of what Netherlands, a developed market, attracted. The country’s leadership is of the view that to turnaround Uganda’s FDI prospects, more tax holidays should be offered to foreign investors.
In August 2016, at the Central Bank’s celebrations to mark 50 years, President Museveni remarked: “…You find that we have got high corporation tax of 30 per cent. My economists say we only tax you when you make profits. That is very good, but if you didn’t tax me, wouldn’t I transform more. And how about the one who taxes less, is he not going to attract more investors than you who is taxing more?”
The President’s approach as well as the country’s focus on tax incentives as a way of attracting FDIs, ignores two established aspects of capital movement in Uganda and in developing markets respectively. One, tax incentives are not a deal breaker for investors in Uganda. According to an Investor Motivation Survey conducted by the Investment Climate Department of the World Bank Group (WBG) in 2012, more than 92 per cent of investors in Uganda that were enjoying tax incentives then, would have still invested their capital even without these incentives.
Two, tax incentives are of limited value when investors are motivated by the desire to access domestic markets or natural resources.
Reinvigorating Uganda’s FDI prospects is still a possibility, but the following question must be answered: Why do foreign investors deploy capital in developing markets?
In their magnum opus titled ‘Multinational Enterprises (MNEs) and the Global Economy,’ Prof John Dunning of the University of Reading and Savianna Lundin of Maastricht University proposed the most well-known framework that differentiates between the motivations of FDIs. According to them, foreign investors are generally motivated by four desires:
Accessing natural resources in the host country eg Barrick Gold Corporation’s investment in Tanzania’s Bulyanhulu gold mine in July 2001;
Accessing the host country’s market eg McKinsey and Company’s investment in opening a local office in Nairobi, Kenya in August 2014;
Acquiring strategic assets of firms in the host country eg IBM’s acquisition of the German technology company IRIS Analytics in January 2016; and
Saving costs through higher production efficiency eg Bombardier Aerospace’s investment in setting up a manufacturing facility for its learjet 85 aircraft in Queretaro, Mexico in October 2010.
In developing markets, however, nearly 90 per cent of foreign investments are predominantly motivated by the desire to access the host country’s domestic market, according to the WBG’s 2017 Global Competitiveness Survey, in which more than 700 business executives of MNEs, with investments in developing markets were interviewed.
With such a credible statistic, Uganda’s leadership should ask: What policy interventions are best suited to attract domestic market seeking investors?
According to the same survey, market seeking FDIs are most responsive to, in descending order, political stability, a clear legal and regulatory environment, market size, macroeconomic stability, availability of talent and skilled labour and the presence of physical infrastructure.
If we are really committed to attracting FDIs, we now know where to focus. For long, we have prioritised tax incentives with disappointing results; it is time to change course.
Mr Tumwenturaho is a structured finance analyst based in Nairobi, Kenya. firstname.lastname@example.org