A few years ago, many western companies were eager to consider investing in Eastern Europe and, more recently, in South Asia, where ongoing reform, large domestic markets, and cheap but qualified labor are transforming the region into a potentially fierce competitor for foreign direct investment (FDI). Although this growing interest was reflected in large commitments by foreign investors announcing major FDI reforms, actual disbursements have been modest. This reflects the investors'concern about the credibility of governments'long-term commitment to change. The credibility of policy announcements is important to investors because the returns from the sunk investment can be affected by later changes in policy. To reduce investors'concern, governments can send clear signals to show their commitment to change. The achievements of trade reform can be an effective indicator of a government's commitment to change as indicated by the strong correlation between increases in trade flows and increases in FDI disbursements. The authors examine how countries can design trade reform to speed up increases in trade. Countries can tailor their commitment to reform to foreign investors by targeting the design of these instruments to the source of their credibility problem. Governments face two credibility problems: 1) investors know the current government's policy preferences (whether they are protectionist or free trade-oriented) but ignore those preferences if the government will later have an incentive to change its position; and 2) investors are uncertain about actual government's commitment to a reform program. The model presented in the paper shows that the recommendations in favor of free trade prevail when investors know the government's preferences and have reason to doubt the government's commitment to a reform program. But in the most realistic scenario in which investors do not know the government's preferences and the policymakers cannot otherwise demonstrate their commitment to reform, a government actually committed to change may want to signal this commitment by subsidizing investments or imports if it wants to be competitive in the market for FDI. In this model, the quickest way to attract FDI is through an investment subsidy, but it is also the most costly -- an import consideration for a reforming government trying to keep tight fiscal control.
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