Against the backdrop of technological advances and new modes of production, how to leverage the potential of FDI to develop the service sector in African low-income countries?

Services now constitute the largest sector in the world economy, accounting for approximately 63.5 percent of global gross domestic product (GDP). They also represent the biggest sector in 194 individual countries among which 30 countries derive more than 80 percent of their GDP from services-related activities. Least developed countries (LDCs) and low income countries (LICs) have also seen a considerable share of their GDP coming from the service sector. As one of the key drivers of economic growth, services will have a significant role to play in enabling these developing countries to meet the sustainable development goals (SDGs) adopted by the international community.

For LDCs and LICs to take full advantage of the economic and social opportunities offered by service sector development, critical injections of foreign direct investment (FDI) are required. However, FDI in those countries is currently concentrated in the extractive sector and in a few economies, although evidence seems to indicate that this is gradually changing.

Moreover, in certain sub-sectors of crucial importance for economic development, such as core infrastructure services, FDI is often constrained by unfriendly regulations coupled with a generally unfriendly investment climate. Many African LDCs and LICs do not have sufficient domestic sources of financing and are unable to adequately fund core infrastructure services such as transport and electricity.

Effective participation in modern production and trade systems is imperative

Two interrelated developments highlight the importance for African countries to give priority to developing their service sectors, as well as the imperative of attracting service sector FDI, among other measures, to achieve this objective: the servicification of production and global value chains (GVCs).

Servicification entails a process whereby non-service sectors in the economy buy and produce more services than before, and also sell and export more services, often as a package deal with goods.[1] Servicification is also fuelled by consumer behaviour in that customers increasingly demand that producers deliver a full package of goods and associated services, thus compelling producers to add services to their business offers in order to stay competitive.

A closely related development is the increasing prevalence of GVCs, which are fuelled by technological advances and organisational changes in the world economy and within transnational corporations. Without doubt, GVCs are a game changer in regard to the way goods and services are produced. They operate on the basis of great levels of specialisation by individual participants, and while they have become the norm in the production of goods, their importance in trade in services has also dramatically expanded. Transnational corporations are increasingly outsourcing parts of their value chains in order to boost efficiency and competitiveness and utilise the lowest worldwide cost options, which in many cases involves contracting out manufacturing or services to an efficient, low-cost producer in a developing country. Today, transactions through GVCs among the various parts of a single corporate system (intra-firm trade) are estimated to account for one third of global trade.

However, the economic viability of GVCs requires firms to have access to quality services at the right time and at a competitive cost. Core infrastructure services such as transport services, ICT services, financial services, and business services are essential for the functioning of GVCs and their presence in a country may have a bearing on whether FDI is channelled to that country or not.

Against the backdrop of limited domestic financing for the development of production capacity in goods and services as well as international trade, FDI in services is critical to enable African LDCs and LICs to be active participants in the servicification of production and to ensure that they are not left out of GVCs. While it is not a panacea for those countries’ development financing needs, the importance of FDI relative to other forms of financing lies in its potential to bring in a package of resources – capital, technology, skills, management, know-how, marketing capabilities, among others – to a host economy.

Attracting FDI into the service sector: Some challenges

Policy Restrictions

A number of restrictions and constraints hamper African LDCs and LICs’ efforts to attract FDI into their service sectors. Restrictions on FDI usually affect both market entry and post-entry operations. The most common entry restrictions include exclusion of foreign investors from certain service sectors, quantitative limitations, whether in the form of quotas or economic needs tests, foreign ownership caps, limitations on the type of establishment, and joint venture requirements. In respect of post-entry barriers, the main restrictions include stipulations regarding the nationality and citizenship of managers or board members, limits to temporary entry of expatriate personnel, and other nationality requirements for staff.

Developing countries, including LDCs and LICs, have embarked on a plethora of policies aimed at increasing their participation in the global economy. Typically, such policies include more trade and investment liberalisation, privatisation, and deregulation. Where FDI is concerned, while the introduction of more welcoming policies has been the general global trend, individual country policies usually include a mixture of measures aimed at both attracting (i.e. tax breaks) and discouraging inflows. While policies intended to attract FDI are usually focused on manufacturing, those restricting inward FDI are mainly concentrated in the service sector.[2]

This is not surprising. Apart from economic reasons such as prudential regulation, because of tendencies towards natural monopoly or other market failures, service sectors such as telecommunications, banking, transportation, and electricity provision are often viewed by host countries as strategic or sensitive. In some cases, infant industry protection arguments have been used in favour of discrimination against foreign investors. As such, FDI in services is typically subject to a broader array of restrictions than investment in the primary or manufacturing sectors.[3]

Investment Climate Constraints

Apart from restrictions of a policy nature, there are also constraints pertaining to the investment climate in African LDCs and LICs that pose serious obstacles to FDI in services, even in cases where the policy environment is fairly liberal.

Inadequate infrastructure and human capital constitute serious constraints: many African LDCs and LICs still lack basic infrastructure services such as roads, health services, or electricity and water utilities. Unsurprisingly, UNCTAD identifies inadequate physical infrastructure as “one of the most fundamental constraints facing LDCs not just to attract diversified types of FDI, but more generally to develop productive capacities, reduce poverty and reap the benefits of economic globalisation.”[4] Unlike in many developing countries, where foreign investors have contributed to bridging the infrastructure gap by building or operating ports, airports, electricity and telecommunication networks, or water systems, only few LDCs have so far been able to attract FDI for infrastructure development at a significant scale.

Another important obstacle lies in the lack of political stability and policy certainty. Some African LDCs and LICs are riddled by challenges of a political-economic nature, including the fact that many of them have unstable political systems characterised by a high level of uncertainty and political risk. In addition to political instability, the likelihood of expropriation contributes to the lack of investor confidence. Predictability of conditions and lack of arbitrariness may be the most important assurance that can be offered to would-be investors.

Further, most African LDCs and LICs have narrow and often fragmented domestic markets, which also represents a serious challenge for attracting FDI. These constraints are aggravated by insufficient liberalisation of intra-regional trade, and thus limited trading opportunities for potential investors. In addition, many African regional integration bodies currently do not include services trade liberalisation agreements (though negotiations in this regard are currently taking place in some regional groupings such as COMESA and SADC).

Finally, African economies also have to face a negative image challenge.[5] In Africa, one of the biggest obstacles LDCs and LICs have to overcome in attracting FDI lies in the negative attitudes towards the continent. Some of the negative perception is based on reality, but a part of it is also due to lack of information about the countries concerned, the reforms undertaken, and the available investment opportunities. The negative image issue is particularly difficult to eradicate, as would-be investors’ lack of information also means that reforms will not have an immediate effect on investment decisions. For this reason, it is necessary for a reforming country – especially when it has a bad reputation due to the failures of previous governments – to embark on serious efforts to improve its international reputation.

Policy recommendations

Any substantial effort to attract investment to African LDCs and LICs should, of necessity, include specific measures targeted at making their service sectors attractive to FDI. These include the following.

• Increasing liberalisation of core infrastructure services and adopting more aggressive marketing strategies about this liberalisation: Some African LDCs and LICs are members of the WTO and have made liberalisation commitments under GATS Mode 3 (commercial presence). Such commitments need to be deepened and enhanced in order to be meaningful. Some of these countries have committed to deeper liberalisation under bilateral investment treaties and unilaterally, yet their true level of openness remains less known by potential investors. It would be in these countries’ interest to liberalise more widely, so as to attract the most competitive firms internationally to establish in their markets, rather than limiting their liberalisation efforts to a few countries which may not have the most competitive services providers.

• Deepening liberalisation regionally and ensuring that regional services liberalisation efforts go much deeper than what is already committed under the GATS: In some regions that are pursuing services negotiations, such as SADC and COMESA, countries have identified core service sectors (mainly producer services, plus tourism) for liberalisation. However, the methodology followed, a positive list approach similar to the GATS, is not likely to lead to deeper or more meaningful liberalisation. If done properly, regional integration has the potential to make LDCs and LICs more attractive to investment by making them part of a bigger market.

• Unilaterally liberalising where feasible: Provided regulations are in place, African LDCs and LICs should be more aggressive in their liberalisation efforts and not be held back by regional and multilateral efforts that typically take several years or decades to conclude. The situation in those countries requires them to take the initiative, while participating in the regional and multilateral negotiations to “lock-in” such unilateral reforms.

• Prioritising appropriate reforms at both local and regional levels: It is trite that mere liberalisation of FDI in the service sector would not automatically produce the desired results. Such liberalisation does require matching regulations. For instance, permitting FDI in a state’s telecommunications monopoly provider without creating conditions of competition or having a strong institutional framework fostering competition may result in merely transferring monopoly rents to foreign investors. Some African LDCs and LICs have very small markets and may not have sufficient clout to properly regulate or protect themselves from powerful monopolies operating at regional levels, hence the need for quality regulation at both local and regional levels. For example, some countries, including some LDCs (i.e. The Gambia), have either set up competition authorities or are in the process of doing so, while also being party to regional competition bodies. A good example of a regional competition authority is the COMESA Competition Commission, which started operations in 2013 and aims to discipline anti-competitive practices that have a regional dimension.

• Building competitiveness in the service sector: Servicification and GVCs make it imperative for all countries to develop services competitiveness, in order not only to avoid being marginalised, but also to be part of and benefit from these new patterns of production and trade in both goods and services. It is critical for LDCs and LICs to build domestic productive capacities through, inter alia, human capital development, capital accumulation, and innovation, in order to be able to maximise the positive effect of FDI across all sectors, and in the service sector in particular.[6]

African LDCs and LICs need to prioritise the service sector by tackling the remaining entry barriers and other constraints related to the investment climate as a whole. Such efforts would include unilateral, regional, and multilateral liberalisation of FDI in the service sector, coupled with appropriate regulation to enhance the benefits of FDI for host countries.

Nkululeko Khumalo is Senior associate at Tutwa Consulting and part-time commissioner at the International Trade Administration Commission of South Africa. This article is an adaptation of a forthcoming conceptual paper to be published by ICTSD.

This article is published under Bridges Africa, Volume 5 - Number 5, by the ICTSD.

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[1] R. Magnus and E. Anér. The New Services Era – Is GATS up to the Task? E15Initiative. Geneva: International Centre for Trade and Sustainable Development (ICTSD) and World Economic Forum, 2014.

[2] UNCTAD. 2006. “Measuring Restrictions on FDI in Services in Developing Countries and Transition Economies”, Geneva.

[3] See for example, UNCTAD. 2004. World Investment Report 2004: The Shift Towards Services, Geneva.

[4] UNCTAD. 2011. Foreign Direct Investment in LDCs: Lessons Learned from the Decade 2001-2010 and the Way Forward, Geneva, p. 14.

[5] D. Honeck. 2011. “Expect the Unexpected?” LDC GATS commitments as internationally credible policy indicators, The Example of Mali, World Trade Organization, Staff Working Paper ERSD-2011-07, 19 May, 2011.

[6] See J. Drake-Brockman and S. Stephenson. 2012. Implications for 21st Century Trade and Development of the Emergence of Services Value Chains, ICTSD, p. 27-28.