Archived — Working Paper Number 24: Canadian Government Policies Toward Inward Foreign Direct Investment

by Steven Globerman, Simon Fraser University and Western Washington University, and Daniel Shapiro, Simon Fraser University, September 1998


Host governments are rarely neutral toward inward foreign direct investment (FDI). Virtually all host governments have barriers to inward FDI of greater or lesser formality, and greater or lesser transparency. At the same time, many governments offer explicit and implicit incentives to foreign-owned multinational companies (MNCs) to establish affiliates in their host markets. Numerous theoretical arguments have been offered for and against barriers to inward FDI; however, the empirical evidence on the impacts of such barriers, as well as their removal, is surprisingly limited and inconclusive given the voluminous literature on the determinants of FDI.1

The policy direction taken by host governments over the past two decades has generally been to liberalize restrictions or barriers to inward FDI. Some observers argue that, while investment-rule liberalization has been popular since the 1980s, there has really been little change in foreign investment accessibility. The reason is twofold: (1) the liberalization of formal rules has not necessarily led to an increase in the transparency of investment regimes, and this lack of transparency is a significant barrier to inward FDI; and (2) informal investment barriers are now relatively more important than formal barriers.2

Whether investment rule liberalization has had a significant impact on inward FDI is ultimately an empirical question, and we shall consider some evidence on this issue for specific Canadian industrial sectors. Perhaps a more fundamental question for public policy is whether host countries should be even more enthusiastic in eliminating the indirect and informal barriers that some observers claim are still important factors discouraging inward FDI. Recently, Canada's Industry Minister called for a new debate on whether existing restrictions on inward FDI in Canada should be retained.

Obviously, any position on this issue is conditioned by the importance of such restrictions to foreign investors; we shall examine their importance for Canada. It will also be conditioned by whether there are net benefits to the host country in continuing to selectively restrict inward FDI. We shall examine this question as well.

The first section of this report, "A Typology of Government Policies toward Inward FDI," identifies and discusses the range of policies that governments can implement to directly or indirectly influence inward FDI, as well as the behaviour of MNCs in the host market. The primary message is that there are many ways in which governments can affect the behaviour of MNCs, and the relative importance of specific policies is likely to vary from case to case.

The following section, "The Policy Context," sets out public policy criteria against which to evaluate the consequences of Canadian government policies toward inward FDI. The goal of promoting higher per capita (real) income levels is obviously of major importance. In this regard, policies restricting inward FDI have two potential impacts. First, they may decrease the quantity of FDI, thereby probably decreasing real income levels in the host country, all other things being constant. Second, they may increase the "quality" of inward FDI. Specifically, to the extent that foreign investors expect to earn economic rent on their investments in the host country, that country's government could potentially "tax away" the rent for redistribution to domestic factors of production. In this context taxes are implicit rather than explicit, taking the form of commitments that investors undertake only because they are required to do so. Examples include substituting more expensive domestically produced inputs for imports that could be more cheaply sourced from other countries, or performing more research and development (R&D) in the host country rather than importing technology from the parent company affiliate. The impacts of FDI policies on the quantity and quality of inward FDI are a focus of this study.

The next section, "Determinants of Inward FDI," reviews the determinants of inward FDI drawing upon the existing economic and international business literature. The review provides background to our own original economic modelling of inward FDI described in our analysis of public policy. "An Overview of FDI in Canada" provides a broad overview of inward FDI patterns to Canada over the postwar period and draws some preliminary inferences about the influence of public policies on inward FDI flows. "Foreign Ownership Policies in Canada" discusses significant Canadian government policy initiatives directed at influencing either the quantity or quality of inward FDI. They include the Foreign Investment Review Act (FIRA), the Investment Canada Act, the Canada-U.S. Free Trade Agreement, the North American Free Trade Agreement (NAFTA) and the World Trade Organization (WTO). Specifically, we describe the main features of these initiatives as they apply to inward FDI, and we consider how they might influence the magnitude and nature of FDI inflows to Canada.

The following section, "Sectoral Policies," identifies Canadian government policies directed at restricting inward FDI at the sectoral level. The sectors concerned are financial services, oil and gas, and communications. The section also provides a theoretical consideration of the welfare economics arguments for and against sectoral foreign ownership restrictions. "The Effects of Public Policy on Foreign Investment" discusses original econometric models of inward (and outward) FDI for Canada. Two sets of models are presented: one for total FDI flows and manufacturing sector flows, and another for financial services and energy. "Foreign Investment in the Oil and Gas Sector" provides a case study analysis of foreign ownership and the effects of foreign ownership policies. The following two sections offer similar case studies of the consequences of foreign ownership and the impacts of foreign ownership policies in the financial services and communications sectors, respectively.

Finally, the last section concludes the paper with a summary and a set of policy recommendations. Our main conclusion is that welfare economics arguments for restricting inward FDI are weak, both at the aggregate level and at the sectoral level. Specifically, inward FDI brings net benefits to the host economy, and it is difficult (for both conceptual and practical reasons) for host governments to extract greater benefits from inward direct investment through screening, the imposition of undertakings or other policies. The most substantial consequence is likely to be a decrease in inward FDI; however, it is easy to exaggerate the effects of direct government policies per se on FDI flows. The overall investment environment seems to be a substantially more important influence on inward FDI patterns, particularly since it reflects the consequences of many government policies not specifically addressing FDI.

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