OECD DEVELOPMENT CENTRE

Working Paper No. 128(Formerly Technical Paper No. 128)

THE CASE OF MISSINGFOREIGN INVESTMENT IN

THE SOUTHERN MEDITERRANEAN

by

Peter A. Petri

Research programme on:Strengthening Links between Developing Countries: Regional Co-operation and Integration

December 1997OCDE/GD(97)196

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TABLE OF CONTENTS

ACKNOWLEDGEMENTS ........................................................................ 6

RÉSUMÉ ................................................................................................. 7

SUMMARY .............................................................................................. 8

PREFACE ................................................................................................ 9

I. INTRODUCTION.............................................................................. 11

II. RECENT INVESTMENT TRENDS ................................................... 15

III. CHARACTERISTICS OF FOREIGN INVESTMENTIN THE SOUTHERN MEDITERRANEAN................................................ 25

IV. FOREIGN INVESTMENT IN A COMPARATIVE CONTEXT ............ 33

V. STRATEGIES FOR ATTRACTING FOREIGN CAPITAL .................. 37

VI. CONCLUSIONS ............................................................................... 47

NOTES .................................................................................................... 49

APPENDIX A: CROSS-SECTION REGRESSION MODELSOF INVESTMENT ................................................................................... 51

REFERENCES ........................................................................................ 55

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ACKNOWLEDGEMENTS

The author, Dean of the Graduate School of International Economicsand Finance, Brandeis University, is grateful to Messrs. Kiichiro Fukasakuand Ulrich Hiemenz, and to Ms. Azita Dastgheib-Kolster for her outstandingresearch support and her constructive comments on a previous draft.

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RÉSUMÉ

Les pays en développement du Bassin sud-méditerranéen n’ont pasprofité de l’expansion remarquable des investissements privés internationauxde ces dernières années. Bien que la région ait été précédemment unedestination privilégiée pour les investissements directs étrangers, sa partdans les IDE mondiaux a décliné. Ainsi, en 1994, les capitaux privésreprésentaient 37 pour cent seulement des entrées de capitaux dans la région(et ils se sont concentrés essentiellement sur l’Égypte et le Maroc), alorsqu’ils atteignent 76 pour cent pour l’ensemble des pays en développement.

Il existe donc un vaste potentiel pour le développement del’investissement étranger dans la région. Les comparaisons économétriqueseffectuées dans l’étude montrent également l’importance des différencesentre les entrées actuelles de capitaux dans la région sud-méditerranéenneet dans d’autres économies comparables. L’émigration et les fuites de capitauxqui ont caractérisé la région par le passé ont créé une réserve de ressourcesqui pourrait permettre de répondre rapidement aux opportunités.

Le document identifie un ensemble de mesures politiques susceptiblesde favoriser les entrées de capitaux privés :

— des mesures au niveau national — dont la privatisation, la libéralisationdes échanges et la convertibilité des monnaies là où elle n’existe pasencore — sont nécessaires pour créer un environnement économiquefavorable à l’investissement privé intérieur et étranger ;

— des accords internationaux — notamment des accords sur les échangeset l’investissement avec les pays de la région et avec l’Europe —favoriseraient la mise en place de marchés et de systèmes de productionintégrés et plus vastes et accroîtraient la crédibilité des politiquesnationales aux yeux des investisseurs étrangers. Du fait de leur structuredu type « centre-périphérie », les accords Europe-Méditerranéepourraient détourner les investissements de la région, aussi devraient-ils être complétés (pour une efficacité accrue) par des mesures delibéralisation plus étendues, impliquant d’autres par tenairescommerciaux.

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SUMMARY

The developing countries of the Southern Mediterranean (SOM) havemissed the extraordinary surge of private international investment in recentyears. Although the SOM region was an important destination for foreigndirect investments, its share of world FDI has declined. In 1994, private capitalrepresented only 37 per cent of the SOM’s capital inflows (of which nearly allwent to Egypt and Morocco) compared to 76 per cent for all developingcountries.

There is great potential for expanding foreign investment in the region.Comparative econometric exercises in the study also suggest large gapsbetween actual inflows into SOM and into similar economies elsewhere.Moreover, the region’s history of emigration and capital flight have created apool of resources that could quickly respond to opportunities.

This paper identifies a cluster of policy initiatives that could help increaseprivate capital inflows:

— domestic measures — including privatisation, trade liberalisation, andcurrency convertibility where it does not already exist — to create aneconomic environment that supports private domestic and internationalinvestment;

— international agreements — including trade and investment agreementsparticularly with European and regional partners — to create larger,integrated markets and production systems, and to enhance thecredibility of domestic policies to foreign investors. As the “hub and spoke”structure of the Europe-Mediterranean agreements could well drawinvestments away from the region, an effective policy combinationtherefore requires that these agreements be complemented with broaderliberalisation measures, involving regional and other important tradepartners.

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PREFACE

During the 1990s many developing countries have embraced a regionalapproach to trade and investment liberalisation alongside their unilateral andmultilateral efforts. This policy trend reflects the belief that regional policyinitiatives can facilitate developing countries’ domestic reforms. Whether theseregional initiatives will indeed bring about such an outcome remains to beproved, however; the crucial factor is the scope and depth of suchcommitments. In this respect, the experience of several SouthernMediterranean countries, in the context of the European Union’s NewMediterranean Policy, will provide useful lessons for policymakers in bothOECD and non-OECD countries.

Following the Europe-Mediterranean Conference held in Barcelona in1995, three Europe-Mediterranean Agreements have already been signed— with Tunisia, Israel and Morocco. Negotiations are underway with severalother countries in the region. The establishment of new agreements helpsthe partnership countries to enhance policy credibility and businessconfidence, though they still need to clear many hurdles to meet the goalsset by these agreements. This is why the Development Centre has undertakenin-depth research on this region — under the theme of “Regional Co-operationand Integration” — as part of its 1996-98 work programme.

This paper, which is the second in a series with respect to the SouthernMediterranean region, addresses a number of policy issues related to thepromotion of private capital flows into the region. This series will make animportant contribution to the policy making of both the OECD and the non-OECD countries concerned.

Jean BonvinPresident

OECD Development CentreDecember 1997

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I. INTRODUCTION

In 1996 private capital flows to developing countries reached $240 billion,six times the 1990 level and four times the peak level reached during thecommercial lending boom of the early 1980s (World Bank, 1997).Representing nearly 5 per cent of the income of developing countries, theseflows have substantially expanded opportunities for investment and growthin the developing world. Foreign direct investment (FDI) flows, in particular,have reached $100 billion (UNCTAD, 1997) and have become a dependableengine of change world-wide; international partnerships are helping toestablish and restructure industries, to facilitate integration into internationalmarkets, and to motivate reform for modernisation and growth.

The developing countries of the Southern Mediterranean1 have largelymissed this extraordinary surge of private international investment. In 1994,for example, private capital represented only 37 per cent of the SouthernMediterranean’s capital inflows compared to 76 per cent for all developingcountries (Table 1). The developing countries of the Southern Mediterraneanaccounted for 3.3 per cent of the GDP of all developing countries, but receivedonly 1.4 per cent of private capital inflows, and nearly all of this went to twocountries, Egypt and Morocco. Had the Southern Mediterranean simplymatched average developing country inflows relative to GDP, it would havereceived additional private capital inflows of 1.9 per cent of world flows, orapproximately $4.6 billion in 19962.

The problem is not lack of international contacts. The SouthernMediterranean is close to major investment sources and has long-establishedtrading relationships with them. Indeed, a parallel study (Petri, 1997) findsthat the region’s overall trade is as high or higher than might be predictedgiven its economic characteristics. But that study also finds that the region’sexports consist to a greater extent of raw materials and relatively slow-growingproducts than those of more successful developing economies. Strongertrade linkages and especially exports of more dynamic products will almostcertainly require complementary investment relationships. Investment, andespecially FDI, would facilitate the technological upgrading that will benecessary for the region’s fuller integration into the world economy.

Unfortunately, it’s not hard to find reasons for why the SouthernMediterranean has lagged in investment inflows. Political tensions and risks,particularly in the Middle East, have been important. Also, except for Egypt,the region’s economies are small and relatively poorly-integrated, andtherefore do not offer the markets needed to attract investors interested inlocal sales. In addition, the region’s investment environment has not been

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particularly hospitable; the economies of several important SOM countrieshave been characterised by extensive state presence in industry, bureaucraticregulation of investment, and limited freedom for international capitalmovements.

Yet the economies of the Southern Mediterranean are turning a corner.Considerable progress has been recently made in macroeconomicstabilisation and growth rates are recovering in many SOM economies.Measures to strengthen capital markets and to privatise state assets havebegun to accelerate, and have been greeted positively by foreign investors.These trends do not apply equally throughout the region, but they do involvesome of the largest economies. They also suggest that foreign capital isready to respond vigorously to improvements in the region’s investmentclimate. The momentum of these developments presents an excellentopportunity to deepen and extend efforts for attracting foreign investment.These efforts, in turn, could help to ensure that the region’s economicperformance continues to improve.

The potential to expand foreign investment is substantial: comparativeeconometric exercises performed in this study suggest large gaps betweenactual inflows into SOM and into similar economies elsewhere. In addition,the region’s history of emigration and capital flight have created a pool ofresources that could respond quickly to opportunities.

In this context, the paper identifies a cluster of policies that could help toincrease private capital inflows. The two main elements of this strategy include:

— domestic measures — including privatisation, trade liberalisation, andcurrency convertibility where it does not already exist — to create aneconomic environment that supports private domestic and internationalinvestment;

— international agreements — including trade and investment agreementsparticularly with European and regional partners — to create larger,integrated markets and production systems, and to enhance thecredibility of domestic policies to foreign investors.

In the context of sound macroeconomic policies, such initiatives couldmake the region more attractive to foreign investors, paving the way for closerintegration with the world economy and more rapid growth. Of course,progress on peace and national political tensions would lend considerableadditional momentum to this process.

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Table 1. Capital Flows to Developing Countries, 1994

Private Capital Per cent of Total Capital($ billion) Total Debt FDI Portfolio

EquityOfficialCapital

Debt FDI PortfolioEquity

OfficialCapital

All LDCs 207 44 80 35 49 21 39 17 24Asia 99 22 44 19 14 22 44 19 14LAC 51 16 21 13 1 31 41 25 2Europe 27 5 8 2 11 19 30 7 41Africa 20 1 3 1 15 5 15 5 75MENA 10 0 4 0 6 0 40 0 60

of which: ($ million) SOM (excl. Israel) 6 170 52 2 148 78 3 893 1 35 1 63 Algeria 1 385 401 18 5 961 29 1 0 69 Egypt 2 623 -260 1 256 10 1 617 -10 48 0 62 Jordan 255 -162 3 0 415 -64 1 0 163 Morocco 1 154 213 601 63 277 18 52 5 24 Syria 331 -26 76 0 281 -8 23 0 85 Tunisia 422 -114 194 0 342 -27 46 0 81

Source: Global Economic Prospects, 1996, World Bank.

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15

II. RECENT INVESTMENT TRENDS

The past decade has not favoured development in the SouthernMediterranean. In earlier periods, the growth rates of the major SOMeconomies ranked relatively high among those of developing countries (Page,1995). Table 2 summarises indicators for the growth and investmentperformance of the Southern Mediterranean, along with four dynamic EastAsian and Latin American economies: Chile, Indonesia, Malaysia andThailand. Data on these “tiger” economies are used throughout this study toexemplify the potential for high performance. The four economies are not toodifferent from those of the SOM region in terms of size, resource endowmentsand levels of development, and are among the most successful economicperformers of recent decades.

As Table 2 shows, the SOM’s average growth was 5.5 in 1975-85, notfar below the 6.1 per cent of the four comparator economies and well abovethe 3.5 per cent of all developing countries. Between 1985-90, the averagegrowth rate of SOM economies sharply decelerated to 1.8 per cent, belowdeveloping country averages, and especially far below the 7.7 per cent growthachieved in the four comparator economies. Although external factors relatedto declining oil prices triggered this decline, the region’s high share of publicinvestment and the impact of government austerity on investment in generalcontributed to the severity of the slowdown.

In 1990-95, growth recovered in the SOM region to 4.6 per cent, againrising above the developing country averages (which were depressed duringthis period by developments in the transition economies), but still far belowthe comparator tigers, which grew at 8.1 per cent. The horizon is brighteningas several SOM countries are now emerging from basic macroeconomicreforms, and are actively improving their investment environment.

Overall Investment

The Southern Mediterranean’s investments have been volatile, and havebeen driven to a large extent by external determinants. The oil price boom ofthe late 1970s and early 1980s placed substantial resources into the handsof governments, giving rise to large bureaucracies and the rapid growth ofpublic enterprise. As Table 2 shows, the share of the public sector in SOMindustry is still 34 per cent on average, nearly three times the 12 per centshare observed in the four comparator tigers. The shares have declinedsomewhat over time, but as shown below, only recently has a seriousprivatisation effort begun.

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Table 2. Growth and Investment in the Southern Mediterranean

GDP GDPper capita

GDP growth Gross domestic investment Value Added by State-Owned Enterprises

($ billion) ($) (% per annum) (% of GDP) (% of GDP)1995 1995 1975-85 1985-90 1990-95* 1975 1985 1995* 1985 1994

Algeria 41.4 1 600 5.8 0.2 0.4 45.1 33.2 32.0 69.9 57.6Egypt, Arab Rep. 47.3 790 8.9 3.9 3.4 33.4 26.7 20.7 37.1 30.0Israel 92.0 15 920 3.4 4.3 6.6 29.4 18.1 23.5 .. ..Jordan (1) 6.1 1 510 .. -3.5 7.4 .. 21.7 26.4 .. ..Lebanon 11.1 2 660 .. .. 6.8 .. .. 26.7 .. ..Morocco 32.4 1 110 4.8 4.4 1.0 25.2 27.1 21.0 18.6 17.2Syrian Arab Republic 16.8 1 120 4.7 1.4 7.3 25.0 23.8 .. .. ..Tunisia 18.0 1 820 5.3 3.0 3.8 28.0 30.2 .. 29.8 30.7West Bank and Gaza 3.2 .. .. .. 0.1 .. .. .. .. .. AVERAGE .. .. 5.5 1.9 4.1 31.0 25.8 25.0 38.9 33.9

Chile 67.3 4 160 4.0 6.5 7.4 17.0 17.2 27.4 13.6 12.9Indonesia 198.1 980 6.8 7.1 7.8 23.7 26.2 37.8 15.4 14.1Malaysia 85.3 3 890 6.9 6.7 8.7 25.3 27.6 40.6 .. 17.0Thailand 167.1 2 740 6.6 10.4 8.4 26.7 28.2 43.1 .. 5.4 AVERAGE .. .. 6.1 7.7 8.1 23.2 24.8 37.2 14.5 12.4

East Asia & Pacific 1 341 800 7.0 7.5 10.0 25.7 32.5 39.0Latin America & Caribbean 1 688 3 320 2.8 2.0 3.0 25.7 18.9 19.5Developing countries 5 393 1 090 3.5 2.8 2.1 .. 23.9 26.8

1. Jordan's latest data on GDP and exports is 1994.* Lebanon GDP growth refers to 1992-95.** Lebanon and Jordan are 1994.

Source: World Development Indicators, World Bank (1997); Bureaucrates in Business, World Bank (1995).

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The oil price cycle of the 1970s and 1980s affected regional investmentthrough both direct and indirect channels such as trade, remittances, loansand grants. In several of the region’s economies, the cycle left behind alegacy of industrial sectors dominated by state enterprises that were bothinefficient and eventually also short of investment funds. As Table 2 shows,investment rates declined sharply in a majority of SOM economies for whichcomparative data are available, both between 1975 and 1985 and between1985 and 1995. By contrast, investment rates rose in the comparator tigersin both periods. SOM investment rates were 8 percentage points above thoseof the tigers in 1975, but they were 12 percentage points below them by1995.

Oil prices had stabilised by the late 1990s, but the external environmentwas not, nor was it likely to be in the near future, favourable enough to driveregional economic growth. In a detailed analysis of the external prospects ofMiddle East and North Africa, Riordan et al. (1995) present several importantsources of concern:

— modest growth in oil revenues;

— rapid population growth;

— diminishing remittance and grant income;

— erosion of preferences for the region’s exports due to the liberalisationand expansion of European Community markets;

— growing competition from economies in the Far East and Eastern Europe.

In short, SOM countries will have to rely on policy reform, increasedsavings and domestic modernisation, rather than external trends, to drivetheir near-term growth.

Trailing the Global Investment Boom

We have seen that the SOM countries did not fully participate in theextraordinary wave of international capital flows that began in the late 1980s.This boom, driven by capital market deregulation in developed countries,the world-wide spread of market-friendly policies, and increased trade andimproved communications, came at an inopportune time for the SouthernMediterranean; the region had not yet adjusted to the economicconsequences of lower oil prices. Only a decade later were conditionsbeginning to fall in place to make the region attractive to substantial foreigninvestment.

The most impor tant form of capital inflow into the SouthernMediterranean is FDI, although privatisation efforts are now beginning toinduce significant portfolio equity flows as well. In the 1970s, the SOM regionaccounted for a substantial share of FDI in developing countries. But then

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world-wide FDI flows increased from $56 billion in 1985 to $343 billion in1996, and in these totals the share of developing countries rose from 21 percent to 32 per cent (see Table 3). In contrast to other developing countries,FDI flows to the Southern Mediterranean increased only modestly in thisperiod, from $1.4 billion to $1.8 billion. Consequently the SouthernMediterranean’s share of world-wide FDI has sharply diminished, from around3 per cent in the late 1970s to under 1 per cent 20 years later (see Figure 1).

Table 3. Global Foreign Direct Investment Boom($ million)

1985 1990 1991 1992 1993 1994 1995 1996Algeria - 0 12 12 15 18 5 4Egypt 1 178 734 253 459 493 1 256 598 800Israel 99 101 350 539 580 206 .. ..Jordan 25 38 (12) 41 (34) 3 43 5Lebanon 7 6 2 4 6 7 35 150Morocco 20 165 317 422 491 551 290 500Syria 37 71 62 67 176 143 65 70Tunisia 108 76 126 526 562 432 264 300West Bank and Gaza .. .. .. .. .. .. .. TOTAL 1 474 1 191 1 110 2 070 2 289 2 616 1 300 1 829

Chile 114 590 523 699 809 1 773 1 695Indonesia 310 1 093 1 482 1 777 2 004 2 109 4 348Malaysia 695 2 333 3 998 5 183 5 006 4 348 5 800Thailand 163 2 444 2 014 2 113 1 804 1 366 2 068 TOTAL 1 282 6 460 8 017 9 772 9 623 9 596 13 911

Developing Countries 24 500 33 500 43 600 67 200 83 700 95 500 109 500World 55 586 201 230 153 840 165 862 210 272 230 953 316 441 343 253

Sources: Global Development Finance (1997), World Bank.

In contrast to more dynamic developing economies, the ratio of FDI toGDP in the Southern Mediterranean still hovers around 0.8 per cent,essentially the same level as it was in the late 1970s (Figure 2). Only Israel,Morocco and Tunisia show trend increases in investment inflows relative toeconomic activity. Egypt’s inflows are the region’s largest, but so far lacksignificant upward momentum. In other regions, the increased role of FDI indomestic production activities brought with it technology and marketinglinkages that helped to integrate the host economy more firmly into worldtrade. As a companion study of SOM trade shows, however, the region’sexport capabilities have remained relatively stagnant (Petri, 1997).

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Figure 1. Share of Southern Mediterranean in World FDI

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

Figure 2. FDI/GDP Ratio in Southern Mediterranean

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

19

77

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

Note: Countries include Egypt, Israel, Jordan, Lebanon, Syria, Algeria, Morocco and Tunisia.

Note: Countries include Egypt, Israel, Jordan, Syria, Algeria, Morocco and Tunisia.Sources: World Development Indicators, World Bank (1997) and UNCTAD (1997).

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The picture has been even less encouraging on private portfolio flows.Among the factors responsible has been the limited development of theregion’s securities markets. Elsewhere, the growth of international capitalflows has been associated with an extraordinary wave of equity marketexpansion (Table 4). The SOM region, including Israel, was an early leaderin emerging stock markets, and accounted for 11 per cent of the capitalisationof such markets in 1983. It then fell far behind other developing regions(Figure 3). From a capitalisation of $115 billion in 1985, emerging marketsgrew to $615 billion in 1990, and approximately $2 226 billion in 1996,representing annual growth rates of 40 per cent and 24 per cent in thesetwo periods. In the meantime, the share of the Southern Mediterraneandeclined to less than one-third of its value a decade earlier, despite risingrelative to the region’s GDP (Figure 4).

Figure 3. Share of Southern Mediterranean in World Stock Market Capitalisation

0%

2%

4%

6%

8%

10%

12%

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

% o

f tot

al E

M

Note: Countries include Egypt, Israel, Jordan, Morocco and Tunisia.

Source: Emerging Stock Markets Factbook, International Finance Corporation (1988 and 1997).

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Figure 4. Stock Market Capitalisation/GDP Ratio in the Southern Mediterranean

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

% o

f GD

P

From the mid-1990s, the Southern Mediterranean’s stock markets beganto awaken (Shafik, 1997). Israel’s market is the largest and deepest in theregion, and attracts significant participation from international investors. Stockmarket capitalisations of Egypt, Morocco and Tunisia have all quadrupled,and new markets have been recently established in Lebanon and Palestine.Also, global depository receipts (GDRs) have been recently issued bycompanies in Morocco (Banque Marocain de Commerce Extérieur), Egypt(Suez Cement and Commercial International Bank), Lebanon (Bank Audi)and Israel (33 companies). As discussed below, privatisation transactionsare an important source of new shares, and are playing a key role in revitalisingregional stock markets.

Note: Countries include Egypt, Israel, Jordan, Morocco and Tunisia.

Source: Emerging Stock Markets Factbook, International Finance Corporation (1988 and 1997).

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Table 4. Emerging Equity Market Capitalisation($ billion; end of period levels)

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996Algeria - - - - - - - - - - - - - -Egypt, Arab Rep. 1.1 1.7 1.4 1.7 2.2 1.8 1.7 1.8 2.7 3.3 3.8 4.3 8.1 14.2Israel 5.1 6.1 7.6 9.9 12.0 5.5 8.2 3.3 6.2 29.6 50.8 32.7 36.4 35.9Jordan 2.7 2.2 2.5 2.8 2.6 2.2 2.2 2.0 2.5 3.4 4.9 4.6 4.7 4.6Lebanon - - - - - - - - - - - - - 0.4Morocco 0.3 0.2 0.3 0.3 0.4 0.4 0.6 1.0 1.5 1.9 2.7 4.4 6.0 8.7Syrian Arab Republic - - - - - - - - - - - - - -Tunisia - - - - 0.7 0.6 0.6 0.5 0.7 0.8 1.0 2.6 3.9 4.3West Bank and Gaza - - - - - - - - - - - - - 0.7

Subtotal 9.2 10.2 11.7 14.7 17.8 10.5 13.4 8.6 13.6 39.0 63.1 48.5 59.0 68.7All Emerging Markets 83.2 92.1 115.2 135.1 331.7 488.6 745.3 614.6 861.6 913.3 1 637.1 1 914.9 1 931.4 2 226.0

Share of Emerging Markets (%) 11.0 11.1 10.2 10.9 5.4 2.2 1.8 1.4 1.6 4.3 3.9 2.5 3.1 3.1

Sources: Emerging Stock Markets Facts Book 1997 and 1988, International Finance Corporation, Washington, D.C., news reports for Lebanon, andWest Bank and Gaza.

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Turning the Corner

In the context of the difficult challenges faced in the 1980s, several SOMcountries adopted policies to improve the economic environment. The firststeps taken in the early 1990s were slow and tentative, but by 1996 therewas noticeable acceleration in the rate of reform as well as economic growth.If sustained, an important turnaround in the region’s prospects could betaking shape.

The first group of important recent reforms involved macroeconomicstabilisation. Egypt’s macroeconomic reforms began in 1990 and had bornefruit by the mid-1990s; the economy is now growing at a 6 per cent rate, withthe government budget deficit below 1.3 per cent. Stabilisation paved theway for rapid, technology led growth in Israel. Jordan’s market-orientedreforms, begun in 1989, halved the country’s debt/GDP ratio, increasedexports, eliminated the budget deficit, and were paying off with solid growth.Morocco and Tunisia have undertaken both macroeconomic and structuralreforms, and have achieved moderate and somewhat volatile growth. TheLebanese economy is making rapid headway, fuelled by a majorreconstruction effort, but the sustainability of these policies is unclear. Abroad-gauged recovery seems underway throughout the region, except forAlgeria and Palestine, where non-economic factors have so far preventedrecovery.

Reforms were gradually accelerating in the 1990s and shifting frommacroeconomic to structural issues. In particular, there has been someprogress in privatisation. In 1996, Egypt sold companies worth nearly$1 billion; $700 million in foreign investments were said to have flown intothe Cairo stock exchange (MEED, 1997). Morocco, Israel and Tunisia alsoprivatised companies, and Jordan and Lebanon also announced substantialfuture sales. Much is left to be done in the privatisation field, but the resultshave been encouraging. These efforts also help to deepen financial marketsand often necessitate parallel reforms (e.g. foreign exchange convertibility)to facilitate international transactions. As a result, SOM investments beganto be rated by major credit agencies, and the Egyptian and Morocco equitymarkets have been included in the International Finance Corporation’s globalequity index.

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III. CHARACTERISTICS OF FOREIGN INVESTMENTIN THE SOUTHERN MEDITERRANEAN

Both the sources and the sectoral destinations of the SouthernMediterranean’s foreign investments differ substantially from those ofeconomies that have claimed larger shares of recent inflows. The sectoralcomposition of SOM investments lacks production-oriented investments thatcould help to integrate the region into international production chains. Thepartner composition, in turn, lacks investors with factor proportions relativelyclose to those of the region itself. These gaps have tended to limit the benefitsof investment inflows from the viewpoint of technology transfer and exportmarket development. There is thus much scope for gains in both the volumeand quality of foreign investment inflows.

Who are SOM’s foreign investors?

There are three important sources of investment in the SouthernMediterranean: Europe, the United States, and Arab investors principallyfrom the Gulf states. The roles of these investors vary substantially acrosscountries (Table 5). Foreign investments in Lebanon, Morocco, Syria andTunisia are dominated by Europe (over 70 per cent) and specifically by France(typically half or more of Europe). The United States plays an important rolein Algeria, owing to energy investments, and in Egypt and Israel, the twolargest recipients of FDI in the region. In general, Europe plays a greaterrole in SOM investment than it does in the inward stocks of the comparatortigers, but the difference is difficult to pin down because the statistical sourcesdo not cover all investment sources.

The striking difference between investment statistics for the SouthernMediterranean and the tigers is the relatively low level of regional investmentinflows. This may be partly a statistical artefact. Investors from the Gulf statesand other Middle East countries are known to play a significant role in theMiddle East, although this role is not evident from the investment statistics.For example, banking surveys show that Arab investors control six of theseven largest foreign-invested banks in Jordan, half of those in Lebanon,and four of ten in Egypt. Oil and mining investments are also often held byMiddle East interests, yet only in Tunisia do investment statistics identify asignificant share of Middle East ownership in any of these industries.

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Table 5. Regional Composition of FDI Inflows(per cent)

Investor RegionHost country Year Europe N. America region MENA Other

Algeria 1995 37 53 9 1Egypt 1995 50 17 1 32Israel 1994 24 51 0 24Jordan .. .. .. .. ..Lebanon 1993 100 0 .. ..Morocco 1995 72 9 3 17PNA .. .. .. .. ..Syria 1993 100 0 .. ..Tunisia 1994 73 1 22 4 AVERAGE .. 65 19 7 16

Chile 1990 18 38 .. 44Indonesia 1988 17 6 15 63Malaysia 1987 27 7 41 24Thailand 1988 15 24 22 38 AVERAGE .. 20 13 26 42

Source: World Investment Directory, West Asia, Volume VI, UNCTAD, 1996.

Even if inflows from regional investors are more important than estimatedin official statistics, these investors play qualitatively different roles in theSouthern Mediterranean region and in the tiger economies. In East Asia andincreasingly in Latin America, the regional investors are often experiencedproducers who recently lost competitiveness due to rising wage rates andseek to transfer their business experience to a new production base. Suchinvestments typically shift technology and markets to economies next in linein comparative advantage, in the spirit of the familiar East Asian “flying geese”analogy. Regional investments in the Southern Mediterranean, by contrast,typically involve financial resources rather than more complex combinationsof capital and know-how. These investors often target relatively passivecommitments in sectors such as banking, real estate and petroleum.

The region’s past capital outflows and its expatriates living abroadrepresent an important potential source of investments. The World Bank hasestimated that accumulated capital flight amounts to $11 billion for theMaghreb region and $31 billion for the Mashreq region, or 12 per cent and46 per cent of GDP respectively. The rate for the Mashreq region is the highestfor any region in the world; it is approximately four times the developingcountry average (World Bank, 1996a, p. 82). Emigrants from SouthernMediterranean also control financial resources and business activities thatcould yield substantial financial, technological and marketing linkages.Estimates of these resources are inherently speculative, but people ofPalestinian origin, for example, have been estimated to own assets of atleast $5 billion (Hiel, 1996). Large concentrations of Egyptian, Lebaneseand North African entrepreneurs also live abroad.

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What do foreign investors do?

The sectoral structure of investment inflows is dominated by a relativelysmall number of sectors:

— petroleum and mining, particularly phosphates;

— basic industries such as chemicals, cement and steel;

— labour intensive export industries such as textiles and clothing;

— finance;

— infrastructure;

— tourism.

Data on the sectoral distribution of investment is unfortunately onlyavailable for rather aggregated, uninformative groupings (Table 6). Whileindustry dominates inflows in the Southern Mediterranean, as in the dynamicdeveloping economies of East Asia and Latin America, anecdotal evidencesuggests that the types of investments within industry are quite different.

Table 6. Sectoral Composition of FDI Inflows(per cent)

Host country Year Primary Secondary TertiaryAlgeria 1995 5 25 70Egypt 1995 4 47 49Israel 1994 0 79 21Jordan 3 56 42Lebanon 1993 .. .. ..Morocco 1995 9 25 41PNASyria 1993 .. .. ..Tunisia 1994 0 91 8 AVERAGE 4 54 38

Chile 1990 63 7 30Indonesia 1988 81 17 3Malaysia 1987 28 41 30Thailand 1988 9 43 48 AVERAGE 39 34 27

Source: World Investment Directory, West Asia, Volume VI, UNCTAD, 1996.

Inflows related to energy are important in Algeria and Egypt, and tourismhas received substantial attention in Jordan, Egypt and Tunisia. Anecdotalevidence suggests that Egypt is also attracting investments associated withits domestic market in building materials and basic industrial and consumergoods. In East Asia and Latin America, investments are more often motivated

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by the desire to establish low-cost production facilities for global markets.Greater integration within the Southern Mediterranean and between theregion and Europe, and improved economic relations between Israel and itsArab neighbours could encourage such investments (say, in garments andelectronics) which often require a marriage of sophisticated technology andlow production costs.

A more detailed impression of the characteristics of investment in theregion can be gained by examining FDI projects reported by the EconomistIntelligence Unit’s quarterly county surveys and Privatization Monthly. AsTable 7 shows, typical projects in the region involved, for example, theconstruction of a German phosphoric acid plant in Morocco, the acquisitionof a large stake in an Egyptian cement company by a Swiss holding company,the purchase of two Israeli semiconductor manufacturers by an Americancompany, and an Italian-Palestinian joint venture in shoe production.Altogether, of the 37 foreign investment-related projects reported over themost recent quarter, 9 involved petroleum, mining and related processingsectors, 10 involved industry, 7 involved services such as finance and tourism,and 11 involved infrastructure.

The bulk of these projects represented relatively large-scale, capital-intensive undertakings in mining, industry and infrastructure, and in particularin petrochemical plants, cement factories and power plants. The capitalbrought in by the foreign investor was undoubtedly necessary for expandingregional output, but the plants were typically “turnkey” facilities typicallyoperated with the help of the foreign partner; technology transfer was likelyto be modest. Less than one-third of the projects involved investments insectors such as electronics, consumer goods, and tourism that were likely toexpand non-resource related exports and to build regional technicalcapabilities. Only two technology-related projects appeared on the list, bothinvolving semiconductor manufacturing in Israel.

The list of actual investment projects differs from those occurring in thecomparator tiger economies, as shown in Table 7. To be sure, investments ineconomies like Chile and Indonesia also have large natural-resourceprocessing components, and the tigers also attract substantial infrastructuredevelopment, but among the Southeast Asian announcements there isevidence of manufacturing projects of a wide range of complexity. In theSouthern Mediterranean, by contrast, production activities have been limitedto downstream processing of raw materials, or the most labour intensiveparts of the production process. Even local-market-oriented production ofintermediate-technology products, say of light household equipment, seemsto be lacking, perhaps because of the limited size of local markets.

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Table 7. Recent Projects Involving Foreign Capital

AlgeriaQ4 1996

• A US-French joint venture considers building a helium-nitrogen plant• Several international joint ventures report investments in oil and gas

exploration and drilling• Fiat moves to start up an assembly plant for 30 000 vehicles• A Saudi joint venture establishes a shipping company

Egypt Q1 1997

• Amoco (US) enters a joint venture to build gas processing and liquefactionplants

• An Italian steel manufacturer forms a joint venture to build a flat productsplant

• BMW decides to start Middle East assembly operations for 2 500 vehiclesnow and 5 000 vehicles by 2000

• Swiss Holderbank acquires 20 per cent equity in the first private cementcompany

• German Lowenbrau considers acquiring 20 per cent equity in the first privatebrewery

• Global One, a French-German-US company, establishes a joint venture tooffer payphone and prepaid phone card services

• Egyptian Electricity Authority lists 11 international firms as qualifiers incompetition to build a private power plant

• Plans are announced to offer GDRs for three large companies Israel Q1 1997

• Applied Materials (US) buys Orbot Instruments and announces intention tobuy Opal, both are semiconductor equipment manufacturers

• Two groups that include Canadian and US investors launch an effort toacquire Bank Hapoalim

• Cable & Wireless (UK), which holds 10 per cent of the state telephonecompany Bezeq, continues its battle for a stronger position; plans areannounced to offer 23 per cent of the company for public sale in New York orLondon

Jordan Q1 1997

• Indian and Japanese companies enter joint ventures to produce phosphoricacid and fertilizer for export to their home markets

• A Syrian cement joint venture modernises its facility• A bank, owned partly by foreign Arab investors, completes a major merger• Government seeks international partners to privatise Jordan Telecom

Lebanon Q2 1997

• France’s postal company is selected to run postal services on a BOT basis• Several banks raise equity funding abroad through GDR issues• A Kuwaiti company announce plans for an airport car-park on a BOT basis• Several foreign companies announce joint construction ventures to build a

new industrial zone at Beirut Airport and to renovate two other airports• Électricité du Liban issues Eurobonds to finance new facilities

Morocco Q2 1997

• A German chemicals company enters a joint venture with a state-owned firmto build a phosphoric acid plant and to source from the plant

• Corral Petroleum (Sweden) buys majority stakes in Samir and SCP• Coca-Cola (US) helps its local distributor to buy a rival soft drinks company• The state power company confirms its intention to seek foreign investors for

several power plants• A US company begins discussions on building a BOT desalinization plant• A French group announces plans to create a $100 million fund to refurbish

tourist facilities Syria Q2 1997

• A Hungarian company is granted an oil exploration contract• Elf, Sumitomo and Petronas (Malaysia) form a joint oil exploration venture• Negotiations commence with foreign companies to develop gas fields• Iran offers to build two cement factories

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Table 7 (fin)

Tunisia Q2 1997

• Several foreign groups enter a competition for a BOO power stationconcession

PNA Q1 1997

• An Italian company enters a joint venture to manufacture shoes• A hotel complex, involving the IFC, the European Investment Bank and Arab

investors, solicits construction bids• A French power company seeks assurances from Israel before moving

ahead with building an electricity generating plant Chile Q1 1997

• A subsidiary of Exxon (US) announces a copper mine investment• A Japanese consortium forms a joint venture for a copper mine investment• A Finnish company enters a joint venture to build a copper smelter• A Spanish company installs telephone lines• The Spanish-invested Banco de Santiago merges with another bank to

become Chile’s largest bank; the government’s shares will be sold on publicmarket

Malaysia Q2 1997

• 122 foreign companies, including the largest names in computers, manyalready investors in Malaysia, apply for incentives in the new “MultimediaSuper Corridor” project

• US West, Deutsche Telekom and Swiss Telecom acquire equity in cellularoperators

Indonesia Q1 1997

• Several international joint ventures announce initiatives in petroleum refiningand petro-chemical production

• A Japanese company enters negotiations to buy 10 per cent of Mobisel• A new national car company receives the first shipment of imported models

from Kia, its Korean partner; speculation mounts on a future link with Toyota• A UK firm commits to funding and building a major container centre on Batam

island on a BOO basis• The state electricity company announces plans to buy electricity from several

international joint venture power companies Thailand Q2 1997

• Seagate (US) completes an expansion of its disk drive manufacturing facility• IBM confirms plans for an assembly facility• Intel considers building a manufacturing facility• A Japanese joint venture brings a steel rolling mill into production• Several international consortia invest in oil and gas exploration and

production

Source: Economist Intelligence Unit, dates and countries as indicated, and Privatization International,Monthly.

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Determinants and effects of the FDI structure

The region’s investment structure reflects, in part, the impact of oil andother non-export sources of foreign income. For example, 29 per cent of theregion’s imports are paid for by revenues other than export earnings,compared to 12 in the comparator tigers (Petri, 1997). The differencerepresents other financing methods, including worker remittances, grantsand net capital flows. Consequently, approximately 20 per cent of imports,or around 10 per cent of GDP which would have been involved in producingtradables output in other developing economies is shifted into non-tradedsectors in SOM countries, for example to sectors such as services andhousing construction. This phenomenon, a Southern Mediterranean versionof the familiar “Dutch Disease”, helps to explain the relative importance ofservices and infrastructure in the region’s foreign investment inflows.

The large role of the state sector has also affected the structure of theSOM economy. The state sector has restricted competition in many of theindustries (including domestic basic industries and export industries) thatforeign investors would have been interested in entering. By raising the costof capital to the private sector, the state sector has also made it difficult forsmaller firms to enter fields that it does not directly control, cutting off anotherset of opportunities for transfers of foreign technology and management skills.

Finally, the segmentation of SOM markets may be responsible for arelative absence of investments in what might be called regional productionsystems, that is, programmes that distribute the regional or global productionactivities of a multinational company across several producing economies.The precursors of such systems are now appearing in Egypt, as investorsare beginning to locate facilities there with some long-term attention to regionalmarkets, but for the time being, the investments have to be justified in termsof Egyptian sales3. The economies of the Southern Mediterranean arerelatively isolated from each other by trade barriers that remain high despitenumerous regional trade agreements (Petri, 1997). In combination withbureaucratic and transport bottlenecks, foreign investors often find it simplerto serve regional markets from foreign production sites.

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IV. FOREIGN INVESTMENT IN A COMPARATIVE CONTEXT

Aggregate trends and anecdotal information suggest that SouthernMediterranean investment inflows lag behind those of more dynamic regions.It is not clear from such casual comparisons, however, to what extent thedifferences from international averages can be attributed to fundamentalstructural features of the region’s economy. The possible scope of the SOM’sinvestment inflows therefore needs to be estimated using analyticalapproaches that control for such structural features. This section reportscomparisons based on an econometric model which predicts investmentinflows using various economic determinants.

FDI Inward Stock

A model of inward FDI stocks was estimated with data on 59 economiesand using determinants including economic size, level of development, humancapital endowment, resource endowment, macroeconomic stability (allmeasured using the proxies mentioned for the export equation), and ameasure of political risk4. The results are shown in Appendix A. The actualinward FDI stock of each SOM economy were then compared to the levelspredicted by the model for that economy, based on substituting the country’sactual structural characteristics into the international cross-sectionrelationship (Figure 5). The results confirm the region’s FDI shortfall. OnlyEgypt lies significantly above the predicted line; in other words, only Egypthas attracted a greater FDI stock than would have predicted given itseconomic structural characteristics. Three SOM countries, Israel, Moroccoand Tunisia, are near predicted levels, while four others, Algeria, Jordan,Lebanon and Syria, are substantially below.

This FDI gap is of great consequence. A recent study of the relationshipbetween growth and FDI suggests that the growth rate increases by0.4-0.9 percentage points for each percentage point increase in FDI inflows,depending on educational levels (higher educational levels increase theproductivity of FDI)5. This is considerably more than the 0.15 percentagepoint growth contribution associated with a percentage-point increase indomestic investment. In other words, if the major lagging economies identifiedabove had attracted inflows around the developing country average of 1.5 percent of GDP, their growth rates would have been, roughly, a percentagepoint higher. Even then, of course, FDI inflows would have been well belowthose of rapidly growing East Asia.

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Figure 5. Predicted and Actual FDI Stock

3

4

5

6

7

8

9

10

11

12

13

14

3 4 5 6 7 8 9 10 11 12 13 14

Predicted

Act

ual

SYR

LEB

MOR

EGY

JOR

ALG

ISR

TUN

Stock Market Capitalisation

As already noted, stock markets are an important vehicle for attractingcapital and for improving the investment climate. How large are SOM stockmarkets relative to international norms? Predictions for stock marketcapitalisation were developed using a cross-section regression specificationparallel to the FDI model described above, using 1995 data on stock marketcapitalisation for the model’s 59 economies. The regression are also explainedin Appendix A. Actual capitalisation levels, with levels for the SOM economieswith labels, are compared to predicted levels based on the regression studyin Figure 6. In terms of stock market capitalisation, only Israel and Jordanare above world norms. Egypt and Tunisia are slightly below internationalnorms, while the Lebanese and Moroccan markets are considerably smallerthan predicted. Algeria and Syria do not have formal equity markets. An

Note: Measured in natural logs.

Sources: Emerging Stock Markets Factbook, International Finance Corporation (1997) and author calculations.

35

equity market was established in Palestine in 1997, and if the capitalisationof $700 million estimated for the market in news publications is accurate, itwill be above international norms for an economy of its size.

Figure 6. Predicted and Actual Stock Market Capitalisation

0

2

4

6

8

10

12

14

16

0 2 4 6 8 10 12 14 16

Predicted

Actu

al

LEB

IS R

JOR

T UN

MOR

EGY

Privatisation transactions represent a major source of growth for SOMfinancial markets. The impact of such market growth will feed on itself, aslarger markets provide incentives for the development of specialisedbrokerage, research and rating services. Such institutions help to makemarkets more attractive to international capital, in turn reducing the cost ofcapital to issuing firms. This then attracts new listings. Such a dynamic hascontributed to the rapid growth of stock markets elsewhere and is nowbeginning to unfold in the Southern Mediterranean as well.

Note: Measured in natural logs.

Sources: Emerging Stock Markets Factbook, International Finance Corporation (1997) and author calculations.

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V. STRATEGIES FOR ATTRACTING FOREIGN CAPITAL

The foregoing analysis suggests that the Southern Mediterranean is“missing” substantial foreign investment; a doubling or even tripling of inflowswould be within the range of experiences observed in other developingeconomies. Some investor concerns, notably those related to peace andpolitical stability, cannot be affected (at least in the short run) by economicpolicy alone, but a great deal can be done to make the investment climatemore attractive.

The “tool kit” available to regional policy makers is substantial andexpanding. It includes a wide range of domestic policies that help to improvethe investment environment, regional and multilateral policies that help tointegrate markets across economies and thus make investments in the regionmore attractive, and international initiatives that enhance the credibility ofpolicies. An effective strategy for revitalising investment will include acombination of such efforts.

Creating an Investment-Friendly Environment

Investment requires profitable opportunities and a regulatory frameworkthat facilitates investment transactions. Policies that ensure generalmacroeconomic stability, integrate markets and open sectors to privateenterprise can help to expand the range of profitable investments. Policiesthat specifically reduce regulatory barriers facing foreign investors and ensurethe repatriation of capital and income are in turn necessary to translate thepotential for profit into viable investment projects.

The necessary reforms have begun in several SOM economies. Countrycredit ratings, providing one indicator of external evaluations of the investmentenvironment, have been improving. Although the ratings reported in Table 8are focused primarily on portfolio investment risks, they measure many ofthe same political and transaction risks that confront direct investment projectsas well. Israel and Tunisia have ratings above the world average; Egypt andMorocco are close. All SOM economies have registered substantialimprovements in their ranking in 1997, and Egypt, Israel and Tunisia receive“investment grade” ratings from at least one of the major rating agencies.Nevertheless, as Table 8 also shows, the region still falls behind thecomparator tigers in investor perceptions.

What can be done to improve the general investment environment?Several SOM economies have made major headway in managingmacroeconomic performance; Egypt, Israel, Jordan, Morocco and Tunisia,

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for example, have sharply reduced government deficits and brought inflationunder control. Although real exchange rates are still somewhat higher thanin East Asia, they are now within a relatively competitive range. The nextmajor policy effort must focus on reducing the government’s role in economicactivity. Eliminating distortions in financial markets is an important step inthis process. Morocco, for example, maintains various measures for loweringthe cost of credit to the government in competition with the private sector,and more than one-third of credit goes to the state or related enterprises.Reducing tariff and other barriers to international trade is another priority(Petri, 1997), and the parallel reduction of trade barriers across the region— creating a larger, integrated market — would further enhance the region’sattractiveness as an investment target.

Table 8. Country Credit Indicators

Institutional Investor Moody's S&P1997 One-year change 1997 1997

Egypt 36.7 2.7 Ba2 BBB-Israel 52.2 1.4 A3 A-Jordan 33.8 3.3 Ba3 B+Lebanon 31.5 5.0 B1 BB-Morocco 39.7 1.5 .. ..Syria 25.0 0.4 .. ..Tunisia 46.3 1.0 Baa3 .. AVERAGE 37.9 2.2 .. ..

Chile 62.0 2.8 Baa1 A-Indonesia 51.6 -0.2 Baa3 BBBMalaysia 67.5 -0.9 A1 A+Thailand 61.1 -2.3 A2 A AVERAGE 60.6 -0.2 .. ..

World Average 40.1 1.2

Note: The ratings are ranked from highest to lowest as follows:Moody's Standard & Poor's

Investment grade Aaa, Aa, A. Baa AAA, AA+, AA, AA-, A+,A-,BBB+,BBB,BBB-Non investment grade Ba, B BB+, BB, BB-, B, B-Default grade Caa, Ca, C, D CCC+, CCC, CCC-, CC, C

Sources: Institutional Investor, March 1997; Moody's and Standard and Poor's, 1997; Shafik (1997),World Bank.

No single policy could do more for improving the region’s overallinvestment environment than an acceleration of privatisation efforts.Privatisation helps to improve economic performance, contributes to thegrowth of financial markets, and builds credibility in overall reform by limitingthe scope of future government involvement in the economy.

While overall privatisation trends are flat in developing countries,transactions in the SOM region have accelerated, reaching $1.2 billion in1995 and $1.4 billion in 1996 (Table 9). Unfortunately, the bulk of these

39

transactions so far involve only three countries: Egypt, Israel and Morocco,and within each of these countries only a limited part of the potential hasbeen tapped so far. Nevertheless, the demonstration effects are likely tofavour privatisation within the three leading countries and eventually also inneighbouring economies. Recent transactions have generated substantialrevenues from both domestic and foreign investors and have been positivelyreceived by the public.

A string of Egyptian and Moroccan success stories are helping to buildpolitical support for further privatisation efforts. In Morocco, for example, theprivatisation programme started slowly but yielded substantial gains for thosewho invested in the first equity issues. The programme benefited workers inprivatised enterprises and gradually increased the number of investors onthe Casablanca stock exchange from 10 000 to 200 000 individuals.Eventually the list of privatisation candidates was expanded to less profitablecompanies, though the pace of sales remained moderate. However, Moroccois privatising the constructi0on of a major power plant and the city ofCasablanca has subcontracted water supply services to a French company.A recent study of the Moroccan experience concludes that the “momentumgained from the privatisation programme has contributed to a rethinking ofthe state’s role in the economy, and has encouraged disengagement fromareas that were previously considered sacrosanct” (Khosrowshahi, 1997,p. 245).

In light of the region’s large infrastructure needs, opening opportunitiesin this sector to private investors (often in partnership with foreign companies)would represent a particularly important mode for attracting capital andstrengthening the investment climate. Smith et al. (1997) estimate that SOMeconomies will require $100 billion in investments over the 1997-2006 period,and that $15 billion of this could come from foreign investors if they participatein the region’s investments to a similar extent as do foreign investors in EastAsia. Moreover, efficient infrastructure services, particularly in transport andcommunications, would help to attract other international investments.

Policies also need to target specific issues of concern to foreign investors.These include rights of establishment, national treatment (for firms alreadyestablished), repatriation of capital and earnings, and fair dispute resolutionprocedures. Some countries have made substantial recent progress inliberalising the financial transactions of foreign investors, but restrictions stillprevail (Table 10). Algeria, Egypt and Syria are still not signatories of theInternational Monetary Fund’s Article 8. Export proceeds have to be partlyor totally surrendered for domestic currency in all SOM economies exceptEgypt, Israel, Jordan and Lebanon, and residents are not allowed to makeforeign capital transactions without approval in all except Lebanon. In mostSOM countries the international transactions of foreign investors face moreliberal terms than those of residents, but all transactions are inevitably morecomplicated in an environment of export and import monitoring and capitalaccount controls.

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Table 9. Privatisation Transactions

1992 1993 1994 1995 1996value value value value value

number ($ million) number ($ million) number ($ million) number ($ million) number ($ million)Egypt - - 2 209 4 122 12 323 18 858Israel 1 235 4 345 2 69 4 637 4 202Morocco - - 4 157 4 249 4 215 7 356Tunisia - - - - - - 1 22 - -Subtotal 1 235 10 711 10 440 21 1 197 29 1 416

Developing Countries 22 623 15 757 16 975 18 887

World 43 473 53 656 63 939 72 537

Source: Privatization Yearbook (1996), London.

41

Table 10. Foreign Exchange Restrictions

CountryIMF Article 8

AcceptedRestrictions on Current Account

Foreign Exchange EarningsRestrictions on Capital Outflows

Algeria - Export proceeds must besurrendered, 100 per cent(fuels) 50 per cent (others) maybe placed in foreign currencyaccounts

Outward investments must besurrendered; approved foreigninvestments can remit capital andincome

Egypt - - Outward investments requireapproval; most foreign investmentsexcept real estate can remit capitaland income

Israel 1993 Export proceeds must be heldin special foreign currencyaccounts

Outward investments by residentsare usually not permitted; foreigninvestors can deposit income andsales proceeds in non-residentaccounts which are freely remitted

Jordan 1995 - Outward investments by residentsrequire approval and are usually notpermitted; foreign investors mayremit capital and income

Lebanon 1993 - -Morocco 1993 Export proceeds must be

surrenderedOutward investments are subject toapproval and must remit incomeearned abroad; foreign investedcapital and income is fullyconvertible through specialaccounts

Tunisia 1993 Export proceeds must berepatriated, 40 per cent can beheld in foreign currency account

Outward investments by residentsrequire approval; foreign investorscan repatriate proceeds from sale ofassets

Syria - Export proceeds must besurrendered

Outward transfers require approval;FDI capital may be remitted onlyafter 5 years

Chile 1977 - Outward investment is broadlypermitted, but is subject toregulation

Indonesia 1988 -Malaysia 1968 Export proceeds must be

repatriated but can be held indomestic foreign currencyaccounts

Outward investment is broadlypermitted, but is subject toregulation; foreign investors mayfreely repatriate proceeds of salesof assets

Thailand 1990 Export proceeds must besurrendered but can be held indomestic foreign currencyaccounts

Direct investment up to $10 millionper year permitted, portfolioinvestment requires approval;foreign investors can repatriateproceeds and interest

Source: Exchange Arrangements and Exchange Restrictions Annual Report 1996, International MonetaryFund.

42

Most SOM economies maintain special incentives for foreign investors(see Shafik, 1997) but few have adopted broad, long-term commitments toopen investment regimes. An appropriate basket of policies can be committedby adopting OECD instruments — such as the agreement on “Liberalisationof Capital Movements and of Current Invisible Operations” or the emergingMultilateral Agreement on Investments — or through regional or bilateralinvestment treaties. Some bilateral agreements of this type have been signedwith the United States (most recently by Jordan) and may be included incertain future Europe-Mediterranean Agreements (for example, withLebanon).

Integrating Regional Demand

Access to the local markets often motivates the initial phases of foreigninvestment in developing countries. Nevertheless, in the contemporary worldeconomy foreign-invested production facilities are often built with an eyetowards forming part of a broader production system, in which a plant initiallydesignated to serve local markets later becomes a specialised source for arange of products marketed internationally. Thus, investments attracted bylocal markets may serve ultimately to integrate the region more closely intothe world economy. Due to the relatively small size of most SOM economies(except perhaps for Egypt and Israel) and high trade barriers among them,SOM markets are typically too small to justify significant local-market-orientedinvestment.

Previous attempts at forming a larger regional market, including theArab Common Market and the Arab Maghreb Union, have not beensuccessful. They have been typically applied in narrow areas such asagricultural co-operation and have excluded most manufactured commoditiesof interest for foreign investors. One reason why this may have happened isthat countries have been unwilling to risk trade diversion to inefficient regionalpartners in the context of their relatively protectionist trade regimes.Successful efforts at regional integration will require parallel multilateralliberalisation.

The Euro-Mediterranean agreements now being considered by severalregional economies present a special challenge. If the EMAs substantiallyreduce barriers facing European producers, and there are no reductions inregional barriers, then the outcome might be stronger incentives forinvestment in Europe, from which all regional economies can be served duty-free. Thus the EMA agreements ultimately provide an important, additionalincentive for building regional markets. Regional agreements would help toavoid the “hub and spoke” implications of bilateral EMA treaties.

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Accession to the European Community has strongly benefited theinvestment appeal of two new “southern tier” members, Portugal and Spain(De Kleine and Riordan, 1995). Portugal’s FDI/GDP ratio increased by2 percentage points in the four years after accession as compared to thefour prior years, while Spain’s increased by 1 percentage point. Theexperience has not been as favourable in Greece, where accession has notbeen accompanied by adequate macroeconomic policies.

Integrating Regional Supply

Investment opportunities can be created also by integrating the region’sproduction system through collaboration among producers and factors ofproduction in different countries. To some extent, general liberalisation helpsto accomplish this goal by facilitating trade in intermediate products. Morefocused policies include improving communications and transport links, andreducing bureaucratic impediments to collaboration across borders.

Short of general liberalisation, regional production co-operation can beencouraged with special economic zones that eliminate barriers selectivelyfor certain producers or production locations. These zones typically includeprovisions for particular forms of collaboration (i.e. special rules for outwardprocessing) and sometimes provide special facilities for handling the entryand exit of imported products from the zone. In some cases, the zones areequipped with the infrastructure necessary for production.

SOM countries have shown considerable recent interest in specialeconomic zones. By 1997, Egypt had six free zones (Alexandria, Suez, PortSaid, Cairo, Damietta and Ismaila) and was planning to set up five more.Jordan had set up zones near Syria, in Zarka and in Aqaba, the last veryclose to the new Israeli free zone in Eilat (Hiel, 1994). Tunisia had anaggressive plan to develop 26 industrial zones to link it and neighbouringeconomies to European and American investors (MEED, 1997), and Moroccoand Syria were also establishing zones. Special zones in Gaza and the WestBank, supported by adequate transport and other infrastructure, could alsohelp to facilitate smoother collaboration between Israeli and Palestinianfactors. Plans have been drafted for a Gaza Industrial Estate in Carni, andfor special zones in Jenin and Tulkarem in the West Bank (World Bank, 1997).The Gaza zone, the World Bank estimates, would cost $50 million to establishand could generate as much as $400 million in annual exports.

The recent rapid development of special economic zones suggests newpossibilities for forming these zones into an international production network.While the individual sites in this network will be competitive to some extent(although eventually they may well specialise in different industry clusters),

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it would be nevertheless in the interest of all sites to collaborate on policiesand infrastructure development. Co-operative efforts might involve sharingtransparent regulations on international investment and trade and co-ordinating policies to facilitate transport and communications among the zonesand with major foreign markets.

The zones, and more general facilitation of international linkages, couldgo a long way toward improving the region’s international competitive positionfor attracting investment. It is said that it takes longer to ship goods throughSOM ports to Europe than from East Asia, due to delays in customs andport processing. The bottlenecks are partly due to red tape and partly toinadequate transport and communications facilities; both need to beaddressed. Privatisation of the provision of related infrastructure servicesmay represent an especially efficient solution, which may also bring benefitsby attracting foreign capital and know-how.

Some of the most promising cross-border investment opportunities,involving projects ranging from small-scale industry and tourism to massiveenergy, water and infrastructure developments, would require co-operationamong countries previously divided by political conflict, including Israel,Jordan, Lebanon, Palestine and Syria. Some of these projects could yieldparticularly attractive benefits by combining Israel’s technology withcomplementary labour and natural resources in neighbouring economies.These opportunities depend, however, on prior political progress.

International Institutional Framework

These policy initiatives will require committed leadership at the nationallevel and close co-operation internationally. International institutions canfacilitate such co-operation and provide support for national policy efforts byfinancing adjustment and co-operative projects. They can also offeropportunities for dialogue, provide a framework for agreements that enhancethe credibility of national reforms, and disseminate policy experience throughthe region. The credibility of reforms can be enhanced through collaborationwith in major international institutions such as the International MonetaryFund and through membership in the World Trade Organisation. Still moredemanding and specific commitments can be incorporated into bilateralinvestment and trade agreements, such as those that the SOM countrieshave concluded or are negotiating with Europe and the United States.

The World Bank and the International Monetary Fund already play acritical role in the Southern Mediterranean by financing adjustment and byoffering technical support for the region’s reforms. (The World Bank’s MiddleEast/North Africa region largely overlaps the Southern Mediterranean regionof this study; it also includes Iran, Iraq and Yemen, but excludes Israel.) The

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Bank and the Fund are also playing an important role by building theintellectual foundations for reform. Their substantial research programmesprovide the most detailed and up-to-date economic analyses available. TheBank and Fund organise major conferences, publish extensive overviews ofregional economic policies, and recently sponsored a large “information fair”to present the experiences of other developing regions to MENA policymakers.

Specialised regional institutions could complement these efforts withmore focused support for regional policy initiatives. The proposed MiddleEast and North Africa Bank (MENA-Bank) could bring additional resourcesand policy expertise to the Southern Mediterranean region. By building closeties to the region’s policy community, the MENA-Bank could more fully engageregional policy makers in analysing problems, in examining collaborativesolutions, and in building a consensus for good policy. It could also benefitfrom a better understanding of regional constraints, though close links to theregion’s policy environment might raise concerns that the MENA-Bank wouldnot be able to apply project criteria as rigorously as larger, more independentinstitutions. To be sure, some forms of lending that should not be acceptableas general practice in development finance might nevertheless be justifiedby the region’s special circumstances, particularly in economies justrecovering from conflict.

East Asian and Latin American governments have developed a rangeof forums to promote regional economic co-operation through liberalisationand trade facilitation. ASEAN and APEC in East Asia play particularlyinteresting roles by addressing a broad and changing agenda, and by involvinga wide range of official and private participants. Indeed, the process of co-operation has partly become the product of these institutions; thespontaneous, wide-ranging contacts they sponsor have stimulated progresson issues well beyond the areas initially identified for co-operation. Theseinstitutions co-ordinate views not just among leaders, but also amongrepresentatives of private companies and many lower-level officials chargedwith international responsibilities.

The Middle East/North Africa Summits, held in Casablanca (1994),Amman (1995) and Cairo (1996) might represent the roots of such aninstitution in the Southern Mediterranean. The 1997 Qatar Summit wassomewhat clouded by setbacks in the peace process. Yet the Summits havedemonstrated substantial private interest in economic co-operation, bothfrom within and from outside the region, provided that the right politicalpreconditions exist. They have also created opportunities for nationaleconomies to showcase improvements in their economies and policies. Itmay not be due to chance, for example, that the Cairo summit of 1996coincided with the acceleration of Egypt’s privatisation programme. This kindof linkage has been also observed in APEC, as countries use their turn ashosts to launch and publicise reform.

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Other forums may also help to promote economic co-operation. Themeetings of the Arab League have been traditionally preoccupied with politicalissues, but recent discussions of a Free Trade Area suggest some interest ineconomic topics. In the past, the political objectives of this forum have meantthat key economic partners such as Europe and the United States could notplay a major role, and that Israel would be altogether excluded. Suchrestrictions limit the value of this forum as a regional economic framework.The multilateral Europe-Asia dialogue launched as part of Europe’sMediterranean initiative has the advantage of involving all major regionaleconomies as well as some important trade partners, but the multilateraldialogue has been intentionally focused on political rather economic issues.The Europe-Mediterranean economic dialogue, in contrast to the politicaldialogue and to APEC and ASEAN, is bilateral and therefore does not supportbroad, multilateral collaboration.

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VI. CONCLUSIONS

The Southern Mediterranean economy is finally in recovery after achallenging decade, but the region has not yet claimed its just share of therecent wave of international investments into developing countries. Althoughthe Southern Mediterranean was an important early destination for foreigndirect investments, its share of world FDI has declined. While SOM stockmarkets accounted for more than 10 per cent of the market capitalisation ofdeveloping countries in the early 1980s, their share has since dropped to3 per cent. Moreover, since SOM investments have focused on infrastructureand relatively capital-intensive projects in primary materials and relatedprocessing industries, they have made more limited contributions to localproduction capabilities than capital inflows elsewhere.

There is great potential for increasing productive investments into theSouthern Mediterranean. The region has strong relationships with majorinvestment source countries and many people with regional backgroundsare wealthy entrepreneurs abroad. Recent reforms, particularly privatisationin Egypt and Morocco, have been greeted positively by international investors.With the help of appropriate domestic and international policy measures,and economic recovery, the region’s economies have good opportunities forincreasing capital inflows.

The principal policy options include measures to improve the domesticenvironment for investment and measures to expand the scope of marketsthrough co-operation with regional partners. An appropriate package ofdomestic measures will include general policies that emphasise privatisationand the liberalisation of trade and capital flows, and specific policies thathelp to improve the framework for transactions involving foreign investment.With respect to international policies, the Europe-Mediterranean Initiativecould be an important catalyst for a wide range of liberalisation measures. Atthe same time, due to the “hub and spoke” structure of the EMAs, theagreements by themselves could well draw investments away from the region.An effective policy combination therefore requires that the EMAs becomplemented with broader liberalisation measures, involving regional andother important trade partners.

Together, this domestic and international policy strategy could add upto more than the sum of its parts. The time is right for market-oriented initiativesat home and for external agreements that deepen linkages with foreigneconomies and lock in domestic reforms. Such efforts will feed on themselvesas the region’s economies benefit from each others’ policies and experiences,and in turn accelerate their reforms.

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NOTES

1. The Southern Mediterranean is defined to include the following economies: Algeria,Egypt, Israel, Jordan, Lebanon, Morocco, Palestinian Authority, Syria and Tunisia.This is a subgroup of the European Mediterranean Initiative’s 12 Mediterraneanpartners. The phrase “developing countries of the Southern Mediterranean” issometimes used to refer to all of these countries except Israel. Southern Mediterraneancountries are far from homogeneous in terms of international economic linkages,levels of development, or cultural backgrounds, but they also share some importantcommonalities in policy, endowments and trade structure. Because of such similaritiesand geographical contiguity, the region’s countries often face similar policy challengesand options for regional and extra-regional partnerships.

2. To keep comparisons with developing countries meaningful, Israel was excluded fromthe SOM region for the purposes of these calculations. Including Israel would notchange the results dramatically, since Israel appears to be on par with internationalnorms in attracting foreign capital.

3. Personal conversations with executives of a large US building systems company.

4. The ICRG political risk index provides a measure of composite business risk basedon a number of financial and economic variables.

5. The estimates in this section are based on data in Borensztein et al. (1995).

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APPENDIX A

Cross-Section Regression Models of Investment

Regression models were estimated to determine how the level of foreigndirect investment and stock market capitalisation in the SouthernMediterranean compare with international norms. Following an approachdeveloped by Chenery (1975) and widely used since, these variables arerelated to a range of explanatory variables that describe the size and structureof a country’s economy. Two types of explanatory variables are used. Thefirst set addresses an economy’s general characteristics (level ofdevelopment, population, education, level of investment), the seconddescribes stability properties that might affect investor confidence (inflation,debt, political risk).

The regression models are estimated in double-logarithmic form, withlog FDI and log stock market capitalisation on the left hand side and logGDP, log population and other variables on the right hand side, as shown inTable A.1. As noted below, this specification is consistent with severalalternative transformations of the FDI, market capitalisation, GDP andpopulation variables.

The sample included 59 countries listed in Table A.2. The overall fit ofthe equations is moderately good, with adjusted R2 values of 0.7 for FDIand 0.8 stock market capitalisation. F-statistics were 24 and 36, respectively.Nevertheless, the standard errors of the regression equations indicateconsiderable noise in the prediction of trade levels, on the order of 100 percent. Although not all hypothesised explanatory variables yield significantcoefficients in all regressions, the variables have been left in the finalestimating equations to show which variable have explanatory power andwhich do not, and to avoid the bias that “data mining” causes in the estimationof standard errors.

The GDP variable is significant in the FDI equation, but just misses the10 per cent significance level in the stock capitalisation equation. In the FDIequation the coefficient is somewhat above one, reflecting the tendency forlarger economies to attract somewhat more than average foreign investment.Population does not enter any of the equations significantly.

Inflation as an indicator of economic stability is a significant and negativeexplanatory factor in both the FDI and the stock capitalisation equations.Neither the debt nor the political risk variable adds much information beyondprice stability in either equation. Gross domestic investment is significantly

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correlated with capitalisation (of course, causation could go either way), butis surprisingly negatively related to FDI stock. This result, which is notstatistically significant, is not supported by most other studies, which findthat FDI is positively correlated with capital formation, even though high levelsof FDI are typically accompanied by some reductions in domestic investment.

Since the model is estimated in double-logarithmic form, its fit is thesame as would be generated by various related specifications involving theFDI, capitalisation, GDP and population variables. For example, the sameprediction for FDI levels would be generated by an equation that has log“FDI/GDP” on the left hand side instead of the current log “FDI” variable. Inthat case, the coefficient of the GDP variable would be reduced by 1. Usingthe example of the FDI equation, the coefficient of the GDP equation wouldbecome 0.152, indicating that each 1 per cent increase in GDP wouldincrease the log of the FDI/GDP ratio by 0.152 per cent. Similarly, the samefit would be achieved if “GDP/population” and “population” were used in placeof the current “GDP” and “population” variables on the right hand side of theequation. The coefficients of these variables would be 1.152 and 1.207(=0.055+1.152), respectively.

Table A.1. Regression Models of FDI Stock & Stock Market Capitalisation

FDI Stock CapitalisationConstant -3.753 ** -1.569GDP 1.152 ** 0.429Population 0.055 -0.144Primary enrolment to primary school age population ratio 0.016 -0.007Debt service ratio at present value 0.010 0.004Consumer price index, average 1984-94 -0.251 * -0.320 **Gross Domestic Investment -0.333 0.943 **Political Risk index, (100 = risk free) 0.025 -0.011

Adjusted R2 0.704 0.818Standard error of estimate 1.070 1.081

Note: GDP, population, CPI and investment variables are in logarithmic form.* Significance at the 90 per cent level.** Significance at the 95 per cent level.

Source: Author calculations.

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Table A.2. List of Countries in the Cross-section Model

OECD: United States Australia Ireland Switzerland Japan Austria Netherlands Turkey Germany Belgium New Zealand Mexico France Denmark Norway Korea Italy Finland Portugal U.K. Greece Spain Canada Iceland Sweden

Eastern Europe: Hungary Poland

Asia: China Malaysia Thailand Hong Kong Philippines Indonesia Singapore

Other Americas: Argentina Colombia Uruguay Bolivia Ecuador Venezuela Brazil Paraguay Chile Peru

Africa and West Asia: Algeria India Lebanon Saudi Arabia Egypt Israel Morocco Syria Ethiopia Jordan Nigeria Tunisia Ghana Kenya Pakistan

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