How South Africa Challenges Our Thinking on FDI
After the fall of apartheid, South Africa accepted the standard prescription for countries to receive more foreign direct investment. Yet FDI has been a mere trickle. Why? The answer may reside in the country's strong corporate environment, says HBS professor Eric D. Werker. Key concepts include:
- South Africa has received just a fraction of the foreign direct investment experienced by other comparable emerging-market economies, challenging some standard views about how FDI works.
- After apartheid, South African conglomerates had money to invest as well as a large market share within their industry.
- Foreign firms or asset managers who want exposure to South Africa might simply choose to go through financial markets.
- A major test of South Africa's infrastructure and security will be World Cup soccer in 2010.
More than one decade after the fall of apartheid, and despite ambitious economic reforms by the ANC government, foreign direct investment flows into South Africa averaged around two-thirds less than investments in comparable emerging-market economies. Why? One reason that could be overlooked is the enduring strength of the corporate climate in South Africa, says Eric D. Werker, an assistant professor at Harvard Business School.
Werker's case study, "Foreign Direct Investment and South Africa," to be published in December, shows that South Africa's experience may debunk standard views of how foreign direct investment works.
"I think a glimpse into private sector flows has shown that our conventional wisdom might not always align with the reality on the ground," he says.
He chose to write on foreign investments in South Africa to provide the School with an up-to-date case capturing some of the dilemmas faced by African economies. South Africa is the largest economy in Africa by quite a distance, and is an illustration of the macro determinates of foreign direct investment, he said.
Werker, whose research is in the intersection of political economy and development economics, primarily in the understanding of foreign aid, is also one of the few economists who studies issues of humanitarian and emergency assistance. One of his papers, on a refugee camp economy, has been accepted by the Journal of Refugee Studies. Another, on vote-buying in the U.N. Security Council, was just published in the Journal of Political Economy.
He recently met with HBS Working Knowledge to discuss his new case and its implications for reinterpreting FDI.
Martha Lagace: How does South Africa challenge conventional views about FDI?
Eric D. Werker: South Africa, since the end of apartheid and its first democratic elections in 1994, was doing everything right. They had liberalized the economy. They had enacted economic reforms that made it easy for foreign capital to flow in and out. They performed well on various surveys of competitiveness and the business environment. The economy was managed spectacularly, with inflation brought down to single digits relatively quickly, budget balances within a reasonable ability to pay, and political stability guaranteed by the ANC's (African National Congress) popularity.
They had undertaken all of these standard prescriptions that the World Bank or the IMF would have advised for countries to receive more foreign direct investment. But interestingly, it was slow in coming.
And so the reasons for this can be many. I think one that might have been overlooked was, in fact, the very strength of the corporate climate in South Africa. Under the apartheid era, the economy was sheltered. Initially, in the 1920s, this had been under an import substitution strategy, but by the '70s and '80s, it was more of a self-defense mechanism. That led to South African corporations' ability to expand and, once they had reached expansion within a particular industry, they would buy up companies in other industries.
Though South Africa is often classified as an emerging economy, it might be more correctly seen as having two economies.
It became a very concentrated corporate structure with basically well-run companies. They weren't running at maximum efficiency because they didn't have much competition from abroad, but given the environment within South Africa, the strongest ones had come to survive and existed in the form of large conglomerates.
When the economy opened up following the end of apartheid and the end of sanctions, these conglomerates shed their non-core assets—which left them cash-rich. What resulted remained fairly concentrated industries, but the companies weren't necessarily the inefficient companies that had characterized the apartheid era.
So South African firms had money to invest. They also had a large market share within their industry; and this, of course, wouldn't be a great environment for someone to go in and set up a new shop. If there are three or four firms sharing an industry, they're probably making money and if you were to come in and undercut on cost, for example, you would have to face the potential retaliatory measures of the stalwarts of the industry.
And with their cash from shedding the non-core assets, South African firms had begun themselves to look for new opportunities.
Q: How is it to do business in South Africa now?
A: It's complex. It would be an intimidating place for a foreign business—without experience in that type of environment—to enter and to prosper in. The crime rate is certainly one of the highest in the world, to the extent that it affects the everyday lives of people and managers. The HIV prevalence rate in South Africa is, like other countries in southern Africa, among the highest in the world.
In addition, though South Africa is often classified as an emerging economy, it might be more correctly seen as having two economies—the normal economy of sophisticated consumers and firms that are investing all over the world, and the rural economy, which still contains many subsistence farmers or folks who are living off of meager agricultural incomes and transfers from the state or their relatives in the big cities. So to compete with all of those site-specific issues would be a challenge. That's not to say it hasn't happened. FDI has gone into South Africa at a rate about one-third of that flowing into Latin America or East Asia.
Q: According to the statistics on FDI in your new case, in "all countries" FDI is 2.7 percent of GDP. South Africa is 1.5 percent.
A: Exactly. Another reason why the FDI numbers weren't as high has to do with the financial market system. Johannesburg has a stock market as it has had for over a century, and business executives I spoke with said that you can get a future contract of ten years on the rand/dollar exchange rate—which is extremely sophisticated. So within financial markets that are pushing the envelope on offering products for an emerging market, the need to go in and set up a business or acquire your own company in order to have exposure to this area is lessened. What many firms or asset managers who want exposure to South Africa would do would be simply go through financial markets. Portfolio inflows that capture those financial market investments are much higher in South Africa than they are for other regions of the world.
Q: Your case describes the complexities of good FDI and "bad" (or at least not so good) FDI in South Africa. Could you tell us about that?
A: Most of that section is to generate class discussion, because the reason that developing countries want FDI is because there is more investment occurring in a country than there is domestic savings, so foreign savings is needed to fill the gap. Once you have a low domestic savings rate, but you still have investment opportunities, you're not only going to get—but you're also going to want—foreign investments so that your country can grow faster.
We generally categorize different types of foreign investment into portfolio and direct investment. Portfolio investment is seen as a volatile source of investment because of whims: Investment managers or hedge fund managers can pull the money out of one country and put it into another or into gold or dollars. And if a lot of investors do this at once, the country could experience a financial crisis. So this is obviously best avoided. Direct investment is seen as a more stable source of foreign savings because it's far less liquid. In the ideal world, it will also bring additional technologies or management skills to the recipient countries.
Through regional development plans, it's easier and cheaper for money to flow from South Africa to its neighboring countries.
Now take a country like South Africa where the domestic corporate scene is actually quite developed and creative, exporting ideas, exporting managers to the multinationals who work there. What sort of foreign direct investment are they likely to receive? Given the concentrated market structure and the high profits of the firms that would be among the several operating there, I think it's not surprising that we should see investments into already successful companies rather than new firms setting up and potentially bringing a new technology or process to the country, except at the innovation frontier where we do see foreign companies setting up.
So even as many in South Africa would see the acquisition of a successful company as potentially not the right kind of direct investment, the fact that it will occur is part of the savings and investment balance. If you don't want that type of investment, you basically need a higher domestic savings rate.
I think the savings rate isn't as high as in many developing countries because of the delay of gratification that's already occurred. Its newly enfranchised black population didn't have access to a lot of economic goods, let alone political power, and as they are acquiring a share in this economy, they're buying cars and houses, and credit is fueling a lot of the current boom. Many of these participants in the economy just haven't had access to very basic things that not only make a middle-class existence more pleasurable but in fact are required for it. I would see the savings rate rising, but not for a while due to all the fairly basic personal infrastructure purchases that are occurring.
Q: What are the advantages and disadvantages of South African firms operating in African markets?
A: Some of the advantages might be unique to the skills that they've developed in South Africa. They're used to innovating to serve poorer clients within South Africa, and the poorer members of the South African population would resemble many of the citizens of other countries in Africa in terms of the products that they would desire and their purchasing ability. Similarly, there's a low infrastructure in many of the countries in Africa, especially outside of the capital, and parts of South Africa would look similar to that. How do you distribute a product to an area without normal stores or major roads? The skills learned in parts of South Africa would be applicable to other parts of Africa.
But South African firms have also come up with new products within sub-Saharan Africa outside of South Africa. For example, the cell phone plans of pre-paid minutes were developed and made extremely efficient in those countries because people just didn't have credit cards or credit ratings so they could do a monthly billing. Those sorts of innovations might not be unique to a South African company, but they could just be what happens when you have a smart company working in sub-Saharan Africa.
Other advantages of South African firms might be less expected. For example, the industry structure in South Africa is concentrated, but it's even more concentrated in other countries in sub-Saharan Africa. There are certain ways to work that would be carryable to other countries in the region. Likewise, there are regulatory advantages that South African firms have to investing in Africa over other parts of the world. Through regional development plans, it's been made easier and cheaper for money to flow from South Africa to its neighboring countries. This gets them, at least relative to their opportunities abroad, an advantage for investing in Africa.
The main disadvantage for South African firms to operate in the African markets is that their risk profile will be correlated. In other words, they're going to be overexposed to Africa from a global portfolio standpoint, which might not be a bad thing after all. Many companies find it optimal to pick their niche rather than to try to completely diversify across risks.
Q: How do you think the South African economy will evolve over the next five to ten years?
A: A major test for South Africa is going to be World Cup soccer in 2010. It's not just because putting on this event will be a logistical challenge, but many in South Africa see it as almost a signal of the country's ability to make the necessary infrastructure investments and to provide the necessary security to the foreigners who will be visiting South Africa for the World Cup.
What it's going to entail is major public investment that is going to be a continued stimulus for the economy. The event may even provide a long enough stimulus that it might be able to turn around some of the sections of Johannesburg that have been abandoned by businesses for the northern suburbs.
I think that commodity prices will remain attractive enough that surrounding economies in Africa will continue to grow, at least in the medium term, and that will create some positive synergies with South African growth. The general global savings glut should ensure that capital still looks for homes all around the globe, including in Africa.
If South Africa is able to meet these infrastructural and security challenges, I think the five following years would bode very well.