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The importance of foreign direct investment

  • Published at 09:59 pm November 7th, 2019
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Saudi Arabia is an attractive country for foreign investors for several reasons, including its market size and state capacity. After falling to $264 million in the fourth quarter of 2017, the Kingdom rebounded robustly and has been steady at around $4bn annually over the last two years.

These are decent numbers, but still fall significantly short of countries with comparable population levels, such as Morocco (around eight times the figure) and Malaysia (around 10 times the figure), indicating that the right strategy by Saudi Arabia could lead to a large increase in inward foreign direct investment (FDI) flows.

Saudi Arabia’s Future Investment Initiative (FII) this year has attracted the world’s top finance leaders under the motto of shaping the future of global investments. Among other things, the conference has already succeeded in bringing to light the importance of global FDIs.

In the period 1990-2008, global FDI flows increased by a factor of 10, equivalent to $2tn, and FDI has become integral to the development strategy of many countries.

The key to benefiting from FDI’s is to distinguish between what makes countries able to attract capital at all from a partner country (what is referred to as the extensive margin), and what makes countries that receive FDI from a partner country able to attract more of that capital (what is referred to as the intensive margin).

To start with, in terms of a country succeeding in attracting any FDI at all, unsurprisingly, the size of the market in the host country is an important positive factor. FDI has upfront overhead costs, such as gathering information about the host country, and making the right legal arrangements. 

A larger market allows these costs to be spread more thinly, while also allowing the investor to exploit economies of scale. In this respect, Saudi Arabia’s $700bn economy, which is among the top 20 in the world, works in its favour.

The empirical insights on the intensive margin yield a longer list of economic factors that work in a host’s favor. The size of the market again renders the host more attractive, as do lower taxes, for obvious reasons. 

Here again Saudi Arabia scores well, despite the recent cuts to subsidies and the rising cost of procuring foreign talent in the Kingdom. In the 2019 edition of the Heritage Foundation’s Index of Economic Freedom, it scored 99.8 out of 100 in the tax burden variable, much to the delight of prospective investors.

Using a common currency, especially the US dollar, also works in a host’s favour. An exotic currency combined with an opaque central bank terrifies investors as they will wonder if they will be able to repatriate their profits and possibly their capital. 

Saudi Arabia’s pegging of its currency, the Riyal, to the US dollar assuages investor concerns, as does the fact that its primary export -- crude oil -- is traded in international markets using the dollar, making it very unlikely that the banking system will run out of greenbacks.

State capacity also constitutes an important consideration for prospective investors for a variety of reasons. In many developing countries, what the government imagines or claims that it can do differs from what it can actually deliver, which makes negotiating with the government over the terms of an investment a precarious enterprise. 

State capacity is also a primary determinant of the quality of critical public goods, such as high quality infrastructure and an effective legal system.

Measuring state capacity is not straightforward; the most popular methods focus on phenomena such as bureaucratic effectiveness. In general, Saudi Arabia performs well in such measures, as evidenced by its good quality infrastructure (ranked 42nd globally in the World Bank’s infrastructure index). 

Notably, this is not an automatic consequence of oil wealth, as many of the world’s most resource-rich countries have perpetually low quality infrastructure.

Corruption undermines state capacity and therefore adversely affects FDI inflows. This presumably played a role in the Saudi government’s aggressive crackdown on corruption at the end of 2017. 

A broad range of legal reforms introduced in the last couple of years also contributed to Saudi Arabia’s 30-position jump in the World Bank’s ease-of-doing-business index, including anti-corruption measures such as publishing court performance reports and information on the progress of cases.

This latter reform is part of a broader trend toward greater levels of transparency, as investors have long complained about the opaqueness of the Saudi legal system. The government’s awareness of this shortcoming is evident in the Vision, which has “embracing transparency” as a primary theme underneath the “effective government” category. 

Dispensing justice alone is insufficient -- governments must also be perceived to be dispensing justice, otherwise investor trust will hit a ceiling.

A lack of transparency has also undermined the initial excitement surrounding Neom, a key pillar of the government’s FDI strategy. Very little official information about the project’s progress has been released, and the resulting speculation adversely affects the Kingdom’s attractiveness to foreign investors.

Nevertheless, the world’s premier companies are sending top representatives to the 2019 FII, and few countries could attract that caliber of participants. 

Ultimately, foreign investors feel that there is a lot of money to be made in Saudi Arabia, and they are confident that the system will allow them to realize and repatriate those profits.

Omar Al-Ubaydli (@omareconomics) is a researcher at Derasat, Bahrain. This article previously appeared on Al Arabiya and has been reprinted by special arrangement.