Columbia FDI Profiles Country profiles of inward and outward foreign direct investment issued by the Vale Columbia Center on Sustainable International Investment January 31, 2011 Editor-in-Chief: Karl P. Sauvant Editor: Thomas Jost Associate Editor: Ken Davies Managing Editor: Ana-Maria Poveda-Garces Inward FDI in Israel and its policy context by Yair Aharoni ∗∗∗ In the first four decades of its existence, Israel was not successful in attracting inward foreign direct investment (IFDI) despite attempts to do so. In the past two decades, Israel have become a haven for multinational enterprises (MNEs) that have taken advantage of its unique assets – among them a skilled, educated workforce and cutting-edge research-and-development (R&D) capabilities – by establishing production lines or R&D centers and acquiring dozens of successful start ups . Israel’s IFDI stock sharply increased from US$ 4.5 billion in 1990 to US$ 71.3 billion in 2009. It is expected that IFDI will further accelerate following Israel's accession to the OECD in May 2010 and as more firms from emerging market economies, including China and India, will come to appreciate its characteristics as an ideal locational choice. Israel also weathered the global economic crisis well, even though IFDI declined sharply. Israel actively encourages IFDI, mainly in high technology areas. In 2010, the Government also created special incentives to attract research centers of financial institutions. Trends and developments Country level developments Israel is a tiny parliamentary republic. Government intervention was very high until the mid-1980s, mainly in the form of an absolute control of the capital market and a high level of import protection. Since July 1985, responsible fiscal and monetary policies have accompanied reforms that have liberalized the economy , freed the capital markets from government's shackles, abolished foreign exchange controls, ∗ Yair Aharoni ([email protected]) is Professor Emeritus, Faculty of Management, Tel Aviv University, an Israel Prize laureate in management science and a Fellow at the Academy of International Business. The author wishes to thank Seev Hirsch and Ravi Ramamurti for their helpful comments. The views expressed by the author of this Profile do not necessarily reflect opinions of Columbia University, its partners and supporters. Columbia FDI Profiles is a peer-reviewed series. 1 reduced the size of the public sector and public debt, accelerated the process of privatization , liberalized foreign exchange rules, and made the economy more competitive. The high quality of human capital has become a great advantage to Israel in seeking a place in the world. Its R&D investment as a percentage of its gross national product (GNP) of 4.7% in 2008 is the highest in the world. So is the number of researchers in R&D per million inhabitants.1 Since the 1980s, the Office of the Chief Scientist (OST) in the Ministry of Industry, Trade and Labor has been operating a variety of programs to support R&D. The Bi-national Industrial Research and Development Foundation (BIRD F) was founded in 1977 and a venture capital industry emerged. Indeed, over the past two decades, Israel has become famous for its capacity for innovation and its highly educated, skilled workforce. Israel's high-tech industry accounted for about 15% of the country's GDP in 2009 (of US$ 195 billion) and more than 75% of its industrial exports. In addition, exports of R&D and software amounted to 29% of services exports and nearly 48% of business services exports in that year. As a result, many high-tech MNEs have established R&D centers and production facilities in Israel. Today, the country's market economy can be characterized as resilient, globally-oriented and advanced-technology-based. The 2010-2011 World Competitiveness Yearbook ranked Israel in 24th place among 139 economies.2 Almost since it became an independent state, Israel tried to attract foreign investors. There were, however, at least four reasons why it was not very successful until the 1990s. First, the Arab countries rejected Israel's right to exist and boycotted firms doing business with Israel. 4 Many perceived Israel as synonymous with conflict and geopolitical instability. Second, Israel was not well developed, and its infrastructure was not at par with that of more developed nations. Telephone services were woefully inadequate and were allocated by the Government on the basis of a priority list. Road construction was inadequate, growing much less than the growth in the number of cars, resulting in congestion and many road accidents. Railways were very few. Even though the economy grew by leaps and bounds up to 1973,4 by 1988 GNP per capita was only US$ 8,100. 5 Third, the tiny size of its domestic market was not very attractive for large MNEs. Finally, the leaders of the country believed in socialist ideology, and the Government intervened in all aspects of business. Most foreign investments were small in size and seem to have been motivated by solidarity of businesspeople in the Jewish Diaspora. By the end of 1980, the IFDI stock was US$ 3.2 billion. Annual IFDI flows during the 1970s were only a few US$ 1 In 2005-2006, there were 4.5 researchers per one million inhabitants in Israel, compared to 2.6 in the United States and 1.3 in China. See UNCTAD, World Investment Report 2007: Transnational Corporations, Extractive Industries and Development (Geneva: United Nations, 2007), table A7. 2 World Economic Forum, Global Competitiveness Report 2010-2011 (Lausanne: WEF, 2010). 3 On the Arab boycott see Aaron J. Sarna, ed., Boycott and Blacklist: A History of Arab Economic Warfare against Israel (Totowa N.J.: Rowman and Littlefield, 1986); Chaim Fershtman and Neil Gandal, “The effect of the Arab boycott on Israel: the automobile market,” Rand Journal of Economics , vol. 29, no. 1 (1998), pp. 193-214 ; Dan S. Chill, The Arab Boycott of Israel: Economic Aggression and World Reaction (New York: Praeger, 1976). 4 Israel’s GDP per capita in relation to the United States increased from 25% in 1950 to 60% in 1970. See Dan Senor and Saul Singer, Start-up Nation: The Story of Israel's Economic Miracle (New York and Boston: Council of Foreign Relations, 2009), p. 115. 5 For more information on Israel until 1990 see Yair Aharoni, The Israel Economy: Dreams and Realities (London and New York: Routledge, 1991). 2 million – the highest being US$ 149 million in 1973. Even as late as 1990, Israel’s IFDI stock as a percentage of GDP was 7.9%, compared to 9.0% for developed countries. In 2009, it was 36.6% compared to 31.5% in the developed world.6 During the past two decades, major changes in Israel's economic policy, the liberalization of the economy and the encouragement of high technology firms and R&D were noticed by foreign MNEs. As a result, the IFDI stock zoomed up to US$ 22.6 billion in 2000 and US$ 71.3 billion in 2009 (annex table 1). Since 2000, annual IFDI flows have been more than US$ 1 billion (annex table 2). Their magnitude fluctuated considerably, with a peak value of US$ 15.3 billion (10.5% of GDP) reached in 2006 – largely because of two major transactions worth about US$ 4 billion each. The decline in IFDI flows in 2009 to US$ 3.9 billion seems to have been more the result of the crisis in the home countries of MNEs and much less of an economic recession in Israel. The sectoral distribution of IFDI is slanted toward high-tech investments - more than half of foreign investments were made in high technology firms and the building up of research centers. The Israeli Central Bureau of Statistics is responsible for the collection of statistical data, including on IFDI. Unfortunately, it does not publish Israel’s IFDI stock in a sectoral breakdown nor does it publish the geographical distribution of home countries. The latest figures available are on output and employment in foreign affiliates in different sectors in 2005 (annex table 3). In that year, foreign affiliates comprised 17% of total manufacturing output (by employing 13% of the total workforce in this sector) and produced 19% of the total output of the services sector (with only 4% of the sectoral workforce). The economic importance of foreign affiliates is very high in the R&D sector (60% of total output and 43% of employees), in computer and related services (38% of output and 23% of employees). IFDI output was also very high in electronic components (54% of output and 32% of employees) and electronic communication equipment (56% of output, 49% of employees). Foreign firms produce half of the value added of high technology firms in Israel. 7 Firms such as Intel, Google or Microsoft rely on their affiliates in Israel for major innovations of new products and processes. As Bill Gates observed "innovation going on in Israel is critical to the future of the technology business." 8 In practice, Israel allows access to foreigners in all economic branches. The main driver for IFDI was the desire to take advantage of innovative entrepreneurs and researchers in Israel and to profit from the institutional arrangements that support them (for details see the policy section). Other drivers have been opportunities to acquire vital components for the value chain. A total of 60% of Israel's exports is done by MNEs – 40% by affiliates of foreign MNEs in Israel and 20% by Israeli MNEs. Most of the exports of these MNEs are directed to affiliated firms. 70% of the service exports of these firms are composed of computer and R&D services.9 The annual average value of IFDI flows in the past decade was 5% of GDP and 28% of gross fixed capital formation in the past three years.