The Gulf countries have enjoyed some success in attracting FDI. There is no secret formula for attracting FDI, but a number of common themes do emerge. They include: open economy, globally inte­grated financial markets, sound domestic government policies and strong human capital.

Gulf governments are making strenuous efforts to attract Foreign Direct Investment (FDI). Business and political leaders across the region have singled out FDI as a key driver of economic growth, prosperity and—perhaps most importantly—jobs for their fast growing populations. It is a challenging task: the Middle East has been slow to embrace the concept of FDI. In 2001, net FDI flows into the GCC states were $202 million. That is a tiny fraction of the global total of $735 billion. Put another way, the Gulf States combined GDP of $312 billion, accounted for some 1% of the world total ($31,300 billion). However, Persian Gulf FDI inflows accounted for just 0.03% of world FDI inflows in the same year. Clearly, the Persian Gulf is underachieving in its quest to attract FDI.

The United Nations Council on Trade and Development (UNCTAD) produces an FDI Performance Index. Each country is given a score. A score of one indicates a country is attracting exactly the right level of FDI for its size. A higher score signifies overachievement, a lower score underachievement. West Asia achieves a score of just 0.11. Of the Gulf States, only Bahrain over performs, with a score of 1.3. Its neighbors do not come close.

Regional lawmakers are finally taking concrete steps to address this imbalance. They are working to create an environment conducive to FDI, and with it the ‘globalization’ of the regional economy. Removing protective trade barriers; drafting new foreign investment laws; forming high-profile agencies to market their countries to global investors. The list is growing and global organizations such as the World Bank and International Monetary Fund (IMF) are spurring them on. "FDI is one form of capital inflow that tends to be positively associated with domestic investment and domestic growth in a relatively consistent manner," says a recent report published by the IMF.

It is clear, then, that the Persian Gulf governments are serious about attracting FDI. But the process throws up a number of searching questions. Why have governments laid such heavy emphasis on FDI as an engine of growth? What success has the region enjoyed so far in attracting FDI? And what more must Gulf governments do to lure the world’s leading companies in the future? The case in favor of FDI is made forcefully by almost all major financial and economic organizations. "The increased reliance on FDI is generally positive for developing countries", says a recent report by the World Bank.

Globalizing Regional Economies: Although globalization has its risks, research shows that countries that undertake policy and institutional reforms in such areas as trade, the financial sector, and governance are better equipped to benefit from increased international trade and capital flows and are, therefore, likely to experience higher gains in per capita income. Economists have long argued that FDI is a vital stimulus for growth in emerging economies. FDI brings a range of benefits, but they can be broadly broken down into two categories: knowledge transfer and capital injection.

In the Middle East and North Africa region, capital flows have traditionally been modest, with FDI flows estimated to be in the order of $2 billion to $3 billion per year in recent years. It values total net FDI flows at $143 billion in 2002.

For the Gulf States, knowledge transfer is critical. The region has been an exporter of capital since the first oil boom of the 1970s; unlike many developing economies, lack of money is not a significant barrier to growth. However, Gulf govern­ments recognize that petrodollars are no longer enough. Today more than ever, they acknowledge that they must make efforts to diversify their economies and stimulate the private sector. To do this, they need to develop the skills, technology and management know-how needed to compete in the global economy.

Knowledge transfer through foreign direct investment is an established vehicle for achieving this. A company such as Microsoft opens a regional headquarters, hiring local workers and managers who develop skills—soft and hard—on the job. This ‘learning by doing’ is one of the central pillars of development economics. While knowledge transfer is crucial, it is not the only argument in favor of FDI. As well as knowledge transfer, stability plays a key role.

Economists have identified six types of capital flows that emerging economies can attract: foreign direct investment, portfolio equity flows, portfolio bond flows, long-term bank credits, short-term bank credits and official flows. Of the six types of capital flows, only two, namely FDI and portfolio equity flows, are positively associated with sub­sequent economic growth rates.

The odd question comes up that why does FDI score higher than portfolio investment on this level? FDI is, by its nature, very stable. If an international company has invested in the bricks and mortar of a factory, it cannot pull out at the first hint of economic or political trouble. By contrast, portfolio investors can and do withdraw their funds almost overnight, often with devastating effects.

In recent years, the textbook example of this is the South ­East Asian crisis of 1997-98. The devaluation of the Thai baht in summer 1997 sent a wave of panic through the region. Western fund managers, who had invested heavily in South East Asian stock markets, withdrew billions of dollars almost immediately, a process that became known as ‘contagion’.

FDI flows are the least volatile of the different categories of private capital flows to developing economies, which is not surprising given their long-term and relatively fixed nature. Portfolio flows tend to be far more volatile and prone to abrupt reversals than FDI. For all these reasons, Gulf governments have won praise for identifying FDI as a key economic driver. However, simply acknowledging the benefits of FDI is not enough. Crucially, governments must attract the right kind of FDI.

UNCTAD singles out key sectors that bring the greatest benefits from FDI. But it also warns that encouraging FDI in the wrong sectors can be a costly error. In short, not all FDI is equally good. "Rapid liberalization of trade and foreign direct investment (FDI) has been the chosen policy approach... in most developing countries in recent years", says UNCTAD. In many cases this has indeed been accompanied by increased participation of developing countries in world trade, including a rapid expansion of their exports. However, their trade expansion has not necessarily been accom­panied by faster growth in their gross domestic product (GDP) and by greater income convergence with industrial countries.

Dynamic Sectors: Now the question that which sectors should countries favor to reap maximum benefit from FDI? UNCTAD produces a league table of the world’s 20 leading ‘market-dynamic’ industries. These sectors have seen the value of exports grow at the fastest rate since the 1980s. Perhaps unsurprisingly, semiconductors and computer equipment are at the top of the list. Telecommunications equipment and pharmaceutical products are also in the top 20, although some more traditional sectors also figure, including silk, cereal and musical instruments.

UNCTAD warns that it is dangerous to draw too many general conclusions from the research. But it does make a few recommendations, some of which are particularly relevant for cash-rich Gulf economies that are striving to move away from traditional, hydrocarbons-based industries. "For many countries, rapid upgrading into market and supply of dynamic products appears to be a more viable strategy for the expansion of industrial activity than extending the existing pattern of production and trade," says UNCTAD, "In this process, technological upgrading can play a crucial role, not only by enhancing the gains from trade, but also by expanding the domestic market through increases in productivity and wages."

Crucially, the role of services in FDI is increasing, particularly financial services and services relating to information technology. Within the region, Dubai has emerged as a pioneer in these fields. Ventures such as Dubai Internet City, Dubai International Financial Market and Dubai Silicon Oasis all fit with the ‘market-dynamic’ sectors that UNCTAD highlights. However, assessing the region’s overall success in attracting FDI is problem­atic. Accurate, timely data is rare (the IMF has for years been calling for better data on regional FDI flows). In the absence of accurately recorded data, organizations such as UNCTAD are forced to use estimates.

Despite these difficulties, it is clear that the region as a whole has enjoyed only limited success in attracting FDI. "In the Middle East and North Africa region, capital flows have tradition­ally been modest, with FDI flows estimated to be in the order of $2 billion to $3 bil­lion per year in recent years", says a recent report by the World Bank. It values total net FDI flows at $143 billion in 2002. George Abed, regional director of the IMF, confirms that the wider Middle East and North Africa region has under performed in securing FDI. "MENA countries are poorly integrated with the world economy," says Abed. "The region receives only one-third the foreign direct investment expected for a developing country of an equivalent size and most if it is concentrated in enclave sectors of a handful of countries."

The real picture is probably significantly brighter than that painted by the UNCTAD figures. UNCTAD economists rely on estimates, and these may well be conservative. For example, UNCTAD estimates that net FDI flows to the UAE were negative in 2001. That is, more foreign investors pulled out of the UAE than arrived. This seems unlikely. The country’s thriving network of free zones continued to attract significant foreign investment in 2001 Dubai, in particular, continued to attract major investment from international companies.

Elsewhere in the region, governments are enjoying increasing success in attracting foreign investment. In Saudi Arabia, Saudi Arabian General Investment Authority (SAGIA) has encouraged a number of investments. In April 2003, HP unveiled plans to open a PC assembly plant in the Kingdom. The plant is HP’s third international assembly plant, after Poland and South Africa. The Kingdom is also in advanced stages of negotiations with major energy companies such as Exxon Mobil and BP about investing in Saudi Arabia’s gas industry.

Also in regional hydrocarbons, Qatar is emerging as a world leader in the upstream and downstream gas industry. Qatar’s growth goes hand-in-hand with international partners such as Exxon Mobil, Phillips and Sasol. Oman has a long­standing partnership with Royal Dutch/Shell, while Kuwait is negotiating with foreign investors about investment in its hydrocarbons sector. Bahrain has attracted significant foreign investment in its offshore financial centre.

Winning Formulas: It is clear, then, that Gulf countries have enjoyed some success in attracting FDI. But what are the winning strategies for securing FDI? There is no secret formula. But a number of common themes emerge. They include: open economy, globally integrated financial markets, sound domestic government policies and strong human capital.

"In particular, the quality of domestic institutions appears to play a role in this respect," says a recent IMF report. A growing body of evidence suggests that it has a quantitatively important impact on a country’s ability to attract foreign direct investment, and on its vulnerability to crises. While different measures of institutional quality are no doubt correlated, there is accumulating evidence of the benefits of robust legal and supervisory frameworks, low levels of corruption, high degree of transparency and good corporate governance.

Studies show that financial globalization can be important, although the link is not crystal clear. UNCTAD shows that More Financial Integrated (MFI) countries attract a far greater proportion of FDI than Less Financial Integrated (LFI) countries. This financial integration tends to promote corporate takeovers and consolidation—a further spur for FDI. Mergers and acquisitions, especially those resulting from the privatization of state-owned companies, were an important factor underlying the increase in FDI flows to MFIs during the 1990s. The easing of restrictions on foreign participation in the financial sector in MFIs has also provided a strong impetus to this factor.

Many Persian Gulf governments score increasingly well on these counts. Moves to develop financial markets are progressing, particularly in the UAE, where Dubai Financial Market and the Abu Dhabi Securities Market have proved successful since their launches. Privatization is forging ahead throughout the Persian Gulf and the formation of a GCC customs union is a key development in breaking down trade barriers.