Provincial Extralegal Investment Incentives in the Context of Decentralisation in Viet Nam: Mutually Beneficial or a Race to the Bottom?

Provincial Extralegal Investment Incentives in the Context of Decentralisation in Viet Nam: Mutually Beneficial or a Race to the Bottom?

June 14, 2013

Between 2001 and 2005, local governments in 32 of Viet Nam's 64 provinces were reported to have violated the central government's investment policies by providing extralegal incentives to foreign investors. The remarkably widespread nature of the violations, referred to here as "investment incentive fence-breaking," has created a clash between the central and local governments, and a competition among provinces themselves in attracting foreign direct investment (FDI). This phenomenon has created a natural experiment for studying the determinants of investment location inViet Nam. This study is the first effort to employ econometric methods (i.e., difference-in-difference techniques) to address two related questions: (i) What are the main factors significantly affecting provincial performance in terms of FDI attraction? and (ii) Did the extralegal investment incentives help provinces attract more foreign investment? The following points summarise our findings and policy recommendations:

Fundamental factors, namely natural resources, human capital, physical infrastructure, and quality of provincial governance, all significantly contribute to the attraction of both registered and implemented FDI.
As regards to the role of "hard" versus "soft" infrastructure, while hard infrastructure helps provinces attract registered FDI, it is soft infrastructure that determines the realisation of FDI.
After controlling for the fundamental factors, the extralegal investment incentives provided by 32 provinces not only have not helped them to attract more FDI, but have increased their fiscal burden. As a result, competition among these provinces has led to a "race to the bottom" while the objective of attracting more FDI has not been achieved.
Compared to the non-fence-breaking group of provinces, the fence-breaking group is poorer, less developed, and less endowed. Given that per-capita FDI, domestic investment, and official development assistance also tend to be higher in better-off provinces, this implies that the gap between the rich and poor provinces continues to widen.
Several factors have contributed to the recent massive fence-breaking. Accelerated fiscal decentralisation since 1996 has forced provincial governments to assume more expenditure responsibility while some traditional sources of revenue have deteriorated. In addition, the growing number of job seekers created by the baby boom after 1975 and the recent trend toward urbanization have presented challenges for local governments. All these factors help explain the temptation of provincial government to provide generous incentives to attract more investment in the hope of addressing both budget and job creation problems. That this fence-breaking could not have happened without the accompanied decentralisation of FDI administration. In a sense, the official decentralisation had helped make the de facto decentralisation happen.
The phenomenal prevalence of fence-breaking shows the determined (indeed desperate) efforts of poorer provinces to attract FDI to facilitate economic growth.To help these provinces, it is recommended that the central government support these provinces by financing infrastructure, investing in human capital, and insuring against exogenous risks. Moreover, to be efficient, centrally funded infrastructure projects should take a regional approach and should not be used as a means to reward or grant favours to individual provinces.
The disadvantaged provinces should be proactive in helping themselves by building up their human capital, improving the quality of provincial governance, creating a good investment environment, and facilitating the development of the private sector.
The fact that almost half of the country exercised some form of fence-breaking seriously questions the validity of the FDI regulation framework up to 2005 and the nature of decentralisation. Therefore, instead of simply punishing the violating provinces, the government should carefully consider the underlying reasons that motivate provinces to fence-break. It may be the case that the problem does not have anything to do with the act of fence-breaking, but with the fence itself. Moreover, a good understanding of positive (or negative) aspects of fence-breaking activities may help identify effective (or ineffective) policies that can be encouraged (or discouraged) in other provinces.
As a final note, a province is labeled as a fence-breaker if it is listed in Decision No. 1387 dated December 29, 2005 of the Prime Minister. "Fence-breaking" as used in this study, therefore, does not necessarily have a negative connotation. After all, the widespread fence-breaking at the dawn of Doi Moi in the 1980s produced a number of remarkably successful policy innovations. Moreover, when a province is referred to as a non fence-breaker, it only means that the province has not been found to issue officially extralegal regulations; it is of course possible that violations have been committed but have not been discovered.

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