Monthly Archives: May 2020

Is There a Future for FDI?—Update

The Organization of Economic Cooperation and Development (OECD), which recently reported on foreign direct investment (FDI) in 2019, has released a new study on the impact of the pandemic on future FDI. The OECD points out notes that FDI flows before the pandemic have been on a downward trend since 2015, and FDI flows in 2018 and 2019 were lower than any years since 2010, suggesting that the decline in FDI will not be reversed when the pandemic eases. This comes as policymakers in the U.S. and elsewhere show concern over Chinese acquisition of domestic firms, and the Chinese government clamps down on Hong Kong’s autonomy.

The OECD report’s authors have optimistic, middle and pessimistic scenarios on the effectiveness of public health and economic policy measures, and their impact on FDI flows in the medium term. Under the optimistic scenario, public health measures are effective in controlling the spread of the virus and economic policies successful in restoring economic growth in the latter half of this year. FDI flows would fall between 30% to 40% in 2020 before rising by a similar amount in 2021 to their previous level. Under the middle scenario, public health and economic policy measures are partially but not completely effective, and FDI flows fall between 35% to 45% this year before recovering somewhat in 2021, but would remain about one-third below pre-crisis levels.  The pessimistic scenario is based on the need for continued measures to contain the virus and repair extensive economic damage, which would lead to drop in FDI flows of over 40% this year and no recovery in 2021.

The impact of an extended decline in FDI will be particularly severe for emerging market and developing economies, which have already seen the reversal of portfolio capital flows. The OECD report points out that the primary and manufacturing sectors, which account for a large proportion of FDI in these economies, have been particularly hard hit during the pandemic. Moreover, the corporate earnings that are a major source of the funding of new FDI expenditures by multinational firms fell in 2019 and will decline further this year.

The decline in FDI will be significant for these economies. FDI flows are usually more stable than other forms of capital flows, but even FDI collapses when it by global turbulence. The parent companies often have the financial resources to assist affiliates in troubled economies, but no advanced economy is escaping the downturn. The decline in spending not only affects the employees in the host country, but also harms domestic suppliers and others who benefit from the activities of the multinational.

The pandemic is also motivating governments to monitor and restrict the acquisition of domestic firms. Several U.S. Senators have urged Treasury Secretary Steven Mnuchin to limit the purchase of U.S. firms with depressed stock prices by Chinese firms. The U.S. has already limited Chinese acquisition of domestic firms in critical sectors, and that will now most likely be expanded to include medical goods and services. Portfolio investment is also under scrutiny. The U.S. Senate has passed a bill that requires foreign companies to allow their records to be audited by the Public Company Accounting Oversight Board in order to sell stock or bonds in the U.S., and the House of Representatives is considering a similar bill. While the bill will affect all foreign firms, it clearly is aimed at Chinese firms.

The U.S. is not alone in acting to restrict foreign investment. Several European countries have mechanisms to review foreign investment in order to protect critical technologies, as do India and Australia. These will now be extended to include medical goods and services. The European Union’s competition chief, Margrethe Vestager, has urged the governments of the EU’s members to purchase shares of ownership stakes in companies in order to prevent foreign takeovers.

FDI to China is also likely to suffer from the Chinese government’s enactment of a new security law for Hong Kong. U.S. Secretary of State George Pompeo’s response that the U.S. will no longer consider Hong Kong to have significant autonomy will not only imperil Hong Kong’s status as an international banking center, but also its role as the major source of FDI for China. The Chinese government’s willingness to forsake that source of funding suggests that it no longer believes that FDI has a critical role to play in the country’s economic development.

FDI, then, faces a range of barriers. The pandemic puts multinational plans for expansion, already scaled back, on hold. The division into a world of competing U.S. and Chinese spheres of influence further reduces the scope of foreign investment. Potential host nations can only hope to be viewed as a feasible site for production by multinationals once the world economy revives.

Is There a Future for FDI?

Among the economic consequences of the coronavirus pandemic will be a drop in foreign direct investment activity. The latest issue of the OECD’s FDI In Figures forecasts a decline of more than 30% in 2020 in FDI flows, even under an optimistic scenario of a recovery in the second half of this year. The falloff reflects not only the deterioration in global economic activity, but also the responses of firms to policies that governments may enact to protect their economies.

The OECD reported that global FDI flows of $1,426 billion, while higher in 2019 than in 2018, nonetheless were below the levels recorded between 2010 and 2017. The increase from the previous year reflected in part that year’s depressed investment expenditures following tax reform in the U.S. and a return to positive outflows from the U.S. FDI inflows to the G20 nations, on the other hand, decreased in 2019, largely due to a drop in inflows to China to the lowest level since 2010.

The decline in FDI flows to China reflects in part the deterioration in relations between the U.S. and China, which has intensified during the pandemic. President Trump blames China for the outbreak of the virus and has threatened to implement new tariffs. The Trump administration is preparing a plan to bring medical supply chains back to the U.S.  Even if Joe Biden is elected President next fall, U.S. and other multinational firms are reconsidering their reliance on Chinese manufacturers in global supply chains.

As the OECD data show, however, this consolidation began before the pandemic. Global supply relationships based solely on cost considerations left firms exposed to external shocks of all kinds, ranging from the Brexit vote to the Japanese tsunami in 2011. In addition, the growth in service exports has allowed firms to locate their operations closer to consumers.

Maria Borga, Perla Ibarlucea Flores and Monika Sztajerowska of the OECD have written about the divestment decisions of multinational firms in a 2019 OECD Working Paper on International Investment, “Drivers of Divestment Decisions of Multinational Enterprises – A Cross-country Firm-level Perspective.” They obtained data on 62,000 foreign owned affiliates in 41 OECD and Group of 20 countries over the period 2007-2014. They found that 22% of the firms that were foreign-owned at the beginning of the period were divested at least once by their parent. The number of divestments was the highest at the beginning of the period during the global financial crisis and generally fell in the following years. Overall, foreign acquisitions outnumbered divestments, but there were years when the numbers were similar, and years when divestments outnumbered the acquisitions.

The paper’s authors undertook an empirical analysis of the decision to disinvest, examining characteristics of the host and home countries as well as of the individual firms. They report that an increase in labor costs in the host country was linked to disinvestment, while an increase in labor market efficiency had the opposite impact. An increase in the control of corruption decreases the probability of divestment, while higher tariffs increase it. Trade openness also increases the probability of divestment, which the authors interpret as a sign of substitutability between FDI and trade. In addition, the existence of a regional trade agreement reduces the probability of divestment.

In projecting the future of FDI, it is important to differentiate between horizontal and vertical FDI. The global supply chains, which evolved in the 1990s and 2000s as information and communication technology improved, represent the latter form. However, Ronald B. Davies of University College and James R. Markusen of the University of Colorado point out in a new NBER working paper, “The Structure of Multinational Firms’ International Activities,” that most of U.S. FDI comes from and goes to other advanced economies, which is suggestive of horizontal FDI.  Similarly, when they look at FDI among country groups, they find that most of the FDI of developed economies takes place amongst those countries. On the other hand, the FDI of U.S. firms that does take place in developing countries occurs in industries that use global supply chains.

If/when the global economy recovers, there may be a resumption of horizontal FDI to take the place of international trade. Firms that face trade barriers may seek to go around them by establishing plants in the countries where they seek to operate, just as Japanese automakers established plants in the U.S. in the 1980s when imports of their cars met resistance. Such a development would be consistent with the finding of Borga, Flores and Sztajerowska that disinvestment and trade are inversely linked. FDI may also pick up if multinational firms seek to establish redundancy by setting up plants outside east Asia.

FDI flows, therefore, will fall precipitously in the short-run. Their recovery will depend on the reconfiguration of the global economy, and how firms respond to government attempts to insulate their economies from foreign shocks. Multinationals will not easily give up historically profitable foreign operations, and will attempt to adapt their activities to surmount whatever new barriers they face. Moreover, the governments of emerging market economies with plummeting GDPs may seek to retain foreign capital to offset the deterioration of domestic economic activity. But it will be a long time before any sort of FDI rebound is recorded.