Barriers to foreign direct investment in services, in South Asia

By Rashmi Banga
Economist at UNCTAD-India

Foreign Direct Investment (FDI) in services has been an important mode of import of services in the South Asia region. South Asian countries have attracted more than US$ 30 billion worth of FDI in 2005. The services where FDI is concentrated include telecommunications, transport, construction, and financial services.

Overall restrictions in FDI

Most countries in South Asia have liberalised equity restrictions on FDI in the services sector to encourage trade under Mode 3, ie, trade through commercial presence. One hundred per cent equity is allowed in many services sectors, in many countries.

As FDI in services has grown, a number of issues have come to the forefront of policymaking. One of the important issues is that of attracting FDI in services where it is most desired, ie, services sectors where domestic capabilities are limited and demand exceeds supply, as, for example, in the transport and telecommunications services.

Taking stock of the liberalisation of services that has taken place in different countries in the region, in the different services sectors, we find that substantial unilateral liberalisation has taken place under Mode 3 in Sri Lanka , Pakistan and Bangladesh . India is yet to embark on the path of unilateral liberalisation. Except for computer and information services and transport (roads), 100% foreign equity in most services is not allowed in India .

Though countries are attempting to attract FDI in many of their services, by liberalising services, the share of the region in global FDI in services is still less than 2%. One of the reasons for this is the existence of barriers to FDI in South Asian countries, in spite of no restrictions on equity ownership. These restrictions may apply at the point of entry, stretching from mere notification requirements to outright prohibition of FDI; others may target the operations of firms; while yet another category may restrict the area of ownership and control.

The restrictions may also vary with the nature of the service. For example, in distribution services, restrictions may include performance requirements, zoning regulations, advertisement restrictions, etc. In professional services, restrictions used are generally of the nature of nationality and residency requirements, and lack of recognition of foreign qualifications. Therefore, even if equity restrictions are removed, there may be other restrictions that may not allow the inflow of FDI into the services sector. Some of the existing barriers to FDI in services in different countries are given below.

Sri Lanka

Sri Lanka has opened its services sector to foreign investment. Foreign ownership of 100% equity is allowed in a range of service sectors such as banking, insurance, telecommunications, tourism, stock brokerage, construction of residential buildings and roads, water supply, mass transportation, production and distribution of energy, professional services, and the establishment of liaison offices or local branches of foreign companies.

However, some of the restrictions that still exist, restricting FDI in services even when 100% equity is allowed, are: foreign commercial banks are allowed to open branch offices in Sri Lanka subject to an economic needs test and approval by the Central Bank. Foreign investors are allowed to hold 100% equity in local banks subject to limits on individual share ownership. Currently, there are only 12 foreign commercial banks operating in Sri Lanka , including one US bank. The government has recently privatised state-owned insurance companies. However, resident Sri Lankans are prohibited from obtaining foreign insurance policies except for health and travel. 

Pakistan

Pakistan generally permits foreign investment in services subject to certain provisions including a minimum initial capital investment of $ 150,000 (investment requirements are higher in financial services). Recent changes in the government's investment policy allow foreign investors to hold up to 100% equity stake and 100% repatriation of profits. The government has opened up the insurance market as one of its financial sector reforms. Foreign investors are allowed to hold up to 51% equity share in companies operating in the life and general insurance sectors.

Foreign investors are also required to bring in a minimum of $ 2 million in foreign capital, and raise an equal amount of equity in the local market. The government issued a new insurance law in 2000 that raised capital adequacy standards and enhanced policyholder protections. The government permits only the parastatal National Insurance Company to underwrite and insure public sector firms.

Source: Various ministry websites in different countries

Private sector firms must meet their re-insurance needs within the country. Only if domestic insurance companies cannot meet their re-insurance needs can they seek outside re-insurance facilities.

Market domination in the insurance sector may pose a significant barrier to entry. The state-owned State Life Insurance Company holds over 76% of the life insurance market, although that number has been declining over the past few years.

Five major domestically-owned companies account for 78% of the general insurance (property, casualty, health) market. Foreign professionals can provide legal and engineering consultancy services, with 100% equity participation.

This reflects a change made in 2004 that eliminated a prior requirement that Pakistanis hold 40% local equity for five years, and reduced the minimal capital requirement for investment in these services from $ 300,000 to $ 150,000.

A legal consultant need not be licensed to practise law in Pakistan . Foreign lawyers, however, may not appear in court or otherwise formally litigate cases unless licensed, even if they work with local lawyers. The Islamabad-based Pakistan Bar Council licenses attorneys in Pakistan , and no de jure prohibition exists against the admission of foreign lawyers to the Bar.

Similarly, foreign doctors must, like their local counterparts, register with the Pakistan Medical and Dental Council, and foreign engineers must register with the Pakistan Engineering Council, in order to practise their respective professions in Pakistan .

Bangladesh

Bangladesh adopted a number of policies and provided generous incentives to attract FDI into the country, and it has perhaps the most liberal FDI regime in South Asia . Due to favourable policies adopted by the government, many sectors have attracted FDI.

The telecommunications sector has emerged as the most attractive sector for FDI. Favourable policies of the government include: a tax holiday for five to seven years; income tax exemption for 15 years for experts in foreign enterprises; protection from double taxation; exemption from duty for importing machinery and spare parts for 100% export-oriented units; eligibility for full working capital loans from local banks on banker-client relationship; the option for foreign firms or joint ventures not to sell their shares through public issues; and protection from expropriation by the State under the Foreign Investment Promotion and Protection Act of 1980. Expatriates' work permits are easily obtained and unhindered remittances of dividends, capital, gains on capital, etc, are allowed.

The Bangladesh government has eliminated the licensing system and simplified government approval procedures for investments in Bangladesh . Bangladesh is also a signatory to the Multilateral Investment Guarantee Agency insuring investors against political risk.

As a member of the World Intellectual Property Organisation (WIPO) and World Association of Investment Promotion Agencies (WAIPA), the country further safeguards the interests of foreign investments. Standard dispute settlement procedures are followed in case there is any dispute with the government or with a private party. If a foreign investor feels his rights have been violated he can file a writ with the high court.

India

With respect to India , many sectors of the Indian economy are still only partially open to foreign investment. The Indian government continues to prohibit or severely restrict FDI in certain politically sensitive sectors such as retail trading, railways, and real estate. At the same time, the government has liberalised other aspects of foreign investment and eliminated various government approvals.

Among the barriers that exist in professional services are: only graduates from an Indian university can qualify as professional accountants in India . Foreign accounting firms can practise in India if their home country provides reciprocity to Indian firms. Internationally recognised firm names may not be used unless they are comprised of the names of proprietors or partners, or a name already in use in India .

Many construction projects are offered only on a non-convertible-rupee-payment basis. Only government projects financed by international development agencies permit payments in foreign currency. Foreign construction firms are not awarded government contracts unless local firms are unable to do the work. Foreign firms may only participate through joint ventures with Indian firms.

Reasons for caution on FDI

There are several reasons why developing countries, on average, remain restrictive on FDI in services or have other barriers to investments in services. Apart from the sensitivity of services with cultural, social, distributional or strategic significance, there are also economic concerns.

First, countries restrict FDI to avoid the risk of foreign investors out-competing domestic investors. Services where domestic investors are not able to cater to the growing demand, or where domestic service-providers do not have the ability or capacity to provide the required quality of services, are where the least barriers exist. These are also services sectors where the government is encouraging FDI. These include infrastructure services like telecommunications.

Second, the sale of public utilities to foreign firms raises complex issues related to privatisation and the regulation of natural monopolies. Countries without the necessary regulatory framework may lose by rushing into liberalisation, particularly when a reversal of liberalisation is hard to achieve or when liberalisation has “systemic implications”, as in the case of the financial industry.

Third, entry by large service transnational corporations involves competition policy considerations and many host countries may not feel ready to deal with the technical and legal issues involved. Industries that are characterised by lack of competition are also likely to be subject to more regulations.

Fourth, it is difficult to assess the impact of liberalisation in a particular service sector, especially if it employs a large number of unskilled people. In such cases, as for example in the distributive services, it becomes important to undertake an in-depth study prior to the decision to allow foreign firms. Many countries lack the will or expertise to undertake such an analysis.

Finally, since a number of services closed to foreign investors are monopolies and, in any event, need to be regulated, domestic regulations are often difficult to put in place.

The above reasons for barriers to FDI in services indicate that though the services sector has provided ample opportunity for trade and growth in the region, it has also, in the process of liberalisation, exposed economies to competition in a sector that, for a long time, has been predominantly under public monopoly. Lack of domestic competitive skills may erode domestic investments in some services. It may also lead to higher prices of services that were earlier available at a subsidised rate under government ownership.

The rise in prices could translate to higher inflationary pressures, reducing the overall welfare of economies.

To circumvent such spirals it is important for the region to have appropriate domestic regulations in place, which will assure better quality of services at affordable prices. Clear domestic regulations increase transparency in the system and encourage foreign direct investment. To sustain the momentum of growth in services trade in the region, conscious efforts should be made to improve the competitive advantage of the region as a whole. Inclusion of trade in services in SAFTA may help attract FDI in services and lead to greater intra-regional trade. Access to more efficient services could lead to higher growth in productivity in other sectors, which, in turn, could improve the overall competitive strength of the region.