WORLD TRADE
ORGANIZATIONWT/WGTI/W/41
3 July 1998
(98-2628)
Working Group on the Relationship
between Trade and InvestmentOriginal:  English
COMMUNICATION FROM ASEAN
The following communication, dated 15 June 1998, has been received from the Permanent
Mission of the Republic of Singapore on behalf of the ASEAN countries with the request that it be
circulated to Members.
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I. INTRODUCTION
1. A characteristic of current policy attitudes towards Foreign Direct Investment (FDI) is the
recognition that it has a beneficial impact on economic development and growth.  This recognition
has been the key impetus behind the search by governments for the appropriate policy instruments to
facilitate and enhance FDI flows and capital accumulation.
2. Investment incentives have long been recognized as useful policy instruments in this respect.
This conventional wisdom is, however, being challenged.  The recent academic debate cautioningagainst the use of incentives has raised doubts about their efficacy and poses important policy
questions for governments.  This paper, however, stresses the contrary.  It attempts to put forward a
case in defence of incentives and their significant role in economic development, trade and
investment.  Its primary objective is to point out that incentives remain a useful policy variable in the
development strategies of governments.
3. The paper is submitted by ASEAN in reference to the discussions on Item II
1 and Item III.12
of the Checklist of Issues and as elaborated in the Note from the Chair, document No. 6004/Rev.2
dated 3 June 1998.
II. GENERAL
4. Arguments on the pros and cons of investment incentives have never been conclusive and are
unlikely to ever be so.  The experience that countries have had with the use of incentives is varied.
There have been some spectacular successes as well as notable failures.  Moreover, methodologiesaimed at impact assessment continue to be at a nascent stage.  The precise impact of incentives on
FDI and trade flows, and more importantly, their impact on the net benefits of FDI on the host country
remain, thus, the subject of some conjecture.
5. What is readily apparent, however, is that incen tives do not, in their own right, determine the
results of the economic strategy deploying them.  Success or failure rides on the interaction of a hostof complex factors and in particular economic fundamentals.  But development experience also points
towards a possible complementary role between economic fundamentals and incentives.  Incentives
                                                     
1 Item II of the Checklist of Issues concerns the economic relationship between trade and investment.
2 Item III.1 of the Checklist of Issues concerns the stocktaking and analysis of existing WTO provisions
in the context of existing international instruments and activities regarding trade and investment.WT/WGTI/W/41
Page 2
can and often do augment the fundamentals that make a country an attractive FDI destination.  The
rationale that investment incentives can help correct market failures was expounded as far back as the
1920s by Prof. A. Pigou in his classic " Welfare Economics ".
III. KEY ROLES
6. Much has been said and written about on the role of incentives.  This paper, however, focuses
on three particular aspects, namely:
(a) the risk premium function of incentives;
(b) the role of incentives as directional tools;  and finally
(c) the relationship between incentives and long-term competitiveness.
A. R ISK PREMIUM FUNCTION
7. Capital importers are fully cognisant of the bottom-line need of investors for acceptable
returns.  Countries compete to provide these returns through a range of economic instruments thatfacilitate an investment friendly environment, su ch as lower tariff structures, skilled workforce,
advanced communications and transport infrastructures.  A failure or inability to provide for such an
economic environment can leave countries at a severe disadvantage in the competition for FDI.
8. Incentives in this context represent country risk premiums, providing a partial counterweight
to poor economic fundamentals, such as lack of infrastructure.  By compensating investors for their
perceived country-specific risks, they provide a reas on for investors to go ahead with a project which
otherwise would have not have been viable at the normal rate of return.  A virtuous cycle of wealth,
income and employment is then sparked off - which in turn will create and facilitate the means to
augment the economic fundamentals.
B. DIRECTIONAL TOOL
9. There is a role for incentives even when countries have got the fundamentals right and FDI is
forthcoming.  Many a policy-maker would attest to the effectiveness of incentives in directing inward
FDI to meeting particular development or regional objectives.  Two examples readily come to mind.
Firstly, the use of incentives to direct FDI flows to wards particular industrial sectors and secondly, the
use of incentives to regulate the type and nature of the FDI received.
10. The idea that governments can adopt domestic policies promoting the development of
particular industries or sectors is not new.  Indeed, it is an idea that underpins much of the way in
which countries formulate their industrial policies.  Incentives remain integral instruments of such
targeting.  In addition to channelling FDI to the targeted industries or sectors, incentives in this
context represent a vital signalling mechanism for governments.  They provide the private sector with
the best clues to the industrial strategies of governments.
11. Incentives also provide an important tool through which countries can regulate the type and
nature of the FDI they receive.  Incentives may help curtail the activities of "fly-by-night" investors.
For instance, the granting of incentives could be ti ed to a commitment to sequential investment in the
form of additional production capacity, modernization, upgrading or diversification into related
products.  Such sequential investments also provide a positive demonstration effect for potential new
investors.WT/WGTI/W/41
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C. LONG-TERM COMPETITIVENESS
12. More importantly, the use of incentives will help to strengthen a country's long-term
competitiveness.  Much of the economic analysis of the impact of incentives tends to be of the static
variety.  However, in the context of  growth in  the long run, incentives can help countries secure
various dynamic benefits which help improve the long-term competitiveness of countries.  Two
examples in particular are worth mentioning.  It is  well known that FDI involves not only a flow of
capital, but the transfer of technology, managerial know-how, skills, network access as well as a ready
made market overseas.  Countries can tap these assets by learning-by-doing over time.  Incentives
help capture precisely the sort of FDI that facilitates this transfer of intangible assets.  The second
type of dynamic gain are economies of scale.  Once investment proceeds and production expands,
efficiency gains are realized.  These could enable a country to secure a comparative advantage in the
industry concerned.
IV. CONCLUSION
13. All of this is not to make trivial the problems associated with the use and administration of
incentives.  Their deployment does require host countries to be prepared to address the caveats that go
along with their use.  Two in particular are worth highlighting.  Firstly, incentives are more likely to
produce positive results in the context of a well thought out macroeconomic strategy.  The latter
cannot be overemphasized.  It provides vital markers against which incentive schemes can beassessed.  And secondly, the effective implementation and monitoring of incentive schemes requires a
concomitant administrative capacity to do.  The capacity to apply incentives varies widely among
countries.
14. These caveats, nevertheless, do not detract from their usefulness as developmental policy
instruments.  The fact still remains that incentives can help attract growth, income and employmentcreating investment and are not intended to support enterprises that are not economically viable.  The
part transfer of income through incentives would not have been politically feasible in the first place if
not for this wealth creation impact.
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