Category Archives: FDI

The Fragmentation of FDI

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The expansion of firms to foreign countries can be traced back to the establishment of the British East India Company and the Dutch East India Company (VOC) at the beginning of the 17th century. U.S. based firms have been involved in foreign operations for over a century. In the 1990s the improvement of information and communications technology allowed managers in the home countries of multinationals to coordinate the activities of their production units in developing economies. FDI flows to those economies grew and their activities contributed to the profits of their parent firms. But recent analysis shows that there has been a slowdown of foreign corporate expansion and changes in its allocation and destinations.

The OECD’s FDI in Figures for April 2024 reports that global FDI flows fell by 7% in 2023, continuing a downward trend following the pandemic. Australia and the U.S. were among the OECD countries with the largest decreases of inflows. Despite this drop, the U.S. remained the largest recipient of FDI inflows ($341 billion) among all countries, followed by Brazil  ($64 billion) and Canada ($50 billion). The report also noted that FDI inflows to the G20 countries fell last year by 34%, and by 46% to the non-OECD members of the G20. The latter figure included major reductions in inflows to China.

The IMF examined the changes in the allocation of FDI in a chapter of the 2023 World Economic Outlook. The authors of the chapter note that the recent fragmentation of trade and capital flows along geopolitical fault lines is a new phenomenon. If these changes in the allocation of direct investment continue (“friend-shoring”), FDI will become more concentrated within blocs of politically aligned countries. Moreover, other forms of capital flows, such as portfolio flows, are not immune to this reallocation.

This relocation of multinational activities will have negative effects on emerging markets and developing economies, which are less likely to be politically aligned with the U.S. or China. These countries depend on FDI for capital and technological deepening, and their own companies benefit from the entry of foreign firms into the domestic economy. Changes in FDI related to vertical integration, which is associated with economic growth, are particularly most costly for these countries. Simulations undertaken by the IMF’s economists project a drop in long-term global GDP of 2%.

The authors looked at FDI flows that included “strategic FDI,” i.e., FDI linked to national and economic security concerns. The flows of strategic FDI to Asian countries, and particularly China, have fallen sharply. On the other hand, this type if FDI was more resilient in Europe and the U.S. The allocations point to a growing  gap between Europe and Asia in this sector.

The issue of fragmentation also appeared in a 2024 IMF Working Paper, “Changing Global Linkages: A New Cold War?” by Gita Gopinath, Pierre-Olivier Gourinchas, Andrea F. Presbitero and Petia Topalova. The authors note that  the reallocation of trade and investment flows among countries is taking place, triggered in part by the tensions between the U.S. and China. They report that trade flows and FDI between a U.S. centered bloc and a China centered bloc has declined by 12–20%, more than trade and investment within countries in the same bloc. However, several nonaligned countries, such as Mexico, Canada and Vietnam, serve as connectors, receiving Chinese goods and reexporting them to the U.S. The global economy, therefore, is not cleaving in half, but it is showing symptoms of fragmentation.

Many of the themes developed in the IMF papers also appear in a recent UNCTAD report, Global Economic Fracturing and Shifting Investment Patterns.  These authors also find evidence of fracturing in global FDI along geopolitical lines and evidence of instability in investment relationships. There is also a gap between investment in the manufacturing and services sectors, with the latter growing in importance. In addition, the authors find evidence of increased FDI in environmental technologies.

A similar assessment of the changes in global trade and investment is offered by Barry Eichengreen in a working paper, “Globalization and Growth in a Bipolar World.” He points out that investment that might have gone from the U.S. to China and vice-versa now is directed to third countries that serve as bridges between the two. This (supposedly) leads to an improvement in national security in exchange for less efficiency. But it may take years to form a quantitative assessment of that tradeoff.

Limitations on FDI flows due to security concerns are a relatively recent phenomenon. They are part of a larger transition to new manifestations of  industrial policy. The downside with such policies is that protectionist motives can guide their imposition and continued use.  Imposing restrictions is always easier than removing them.

The Impact of FDI Income on Income Shares in Home Countries

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Income generated by foreign direct investments (FDI) has grown since the 1990s, and now represents a substantial portion of many countries’ current accounts. Some of these flows are routed through Special Purpose Entities in financial centers that multinational firms use to minimize their tax liabilities. We use IMF and OECD data to evaluate the impact of this income on the income share of the top 1% of households in the multinationals’ home countries. We distinguish between FDI equity income and FDI interest income arising from intra-firm lending. We also consider separately the effects in advanced economies rom those in financial centers. FDI equity income contributes to the income share of the top 1% of households in advanced economies, while FDI interest income has no impact in these economies. Similar results for these countries are recorded when we use the OECD non-SPE data. As a result, total FDI income reinforces the income share of the top 1% of households in these countries. While there is some evidence of a similar impact by FDI equity income on the top 1% of households in the financial centers, this result is not apparent when non-SPE income data are used.

See paper here.

Risk and FDI

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While FDI flows recovered in 2021 from the previous year’s decline, not all countries benefitted from the increase. UNCTAD reported that almost three quarters of global FDI flows in 2021 occurred in advanced economies, and China and other Asian economies recorded the largest increases amongst the emerging markets and developing economies. Multinational companies are evaluating the course of the pandemic in those countries and their suitability for new global supply routes. Risk, always a factor in FDI decisions, has become an even more important concern.

There are, of course, many forms of risk. Neil M. Kellard, Alexandros Konotonikas and Stefano Maini of the University of Essex with Michael J. Lamla of Leuphana University Lüneburg and Geoffrey Wood of Western University examined the effects of financial system risk in “Risk, Financial Stability and FDI“, published in the Journal of International Money and Finance this year (working paper version here). They specifically investigated the impact of risk on inward FDI stocks within 16 Eurozone between 2009 and 2016, and used bilateral data drawn from the origin countries and host economies to compare the effects of different forms of risk in both locations.

Their results indicated that an increase in risk in the banking sector of an origin country—as measured by the proportion of non-performing loans—led to a decrease in FDI in the host countries. However, changes in bank risk in the host country had no similar impact. They interpret this result as indicating that multinationals are dependent on bank financing in their origin countries to finance their expansion.

In addition, inward FDI was negatively linked to upturns in sovereign yields in both the origin and host countries. The impact of the sovereign yield variable in the origin countries was larger than that of the corresponding yield in the host countries. They interpret the latter results as showing that an increase in sovereign risk in the origin country discouraged risk-taking by multinational firms based there, while the increase in risk in the host country caused multinationals to turn to other hosts. Moreover, when they separated the Eurozone countries into two groups, with Greece, Ireland, Italy, Portugal and Spain as the stressed group, they found that the size of the impact of the sovereign risk variables was comparatively larger in the stressed group.

Risk is also the subject of a recent NBER working paper by Caroline Jardet and Cristina Jude of the Banque de France and Menzie Chin of the University of Wisconsin-Madison, “Foreign Direct Investment Under Uncertainty: Evidence From A large Panel of Countries.” They examined host country “pull” factors and global “push” factors for inward FDI flows in a panel of 129 advanced, emerging market and developing economies over the period of 1995 to 2019. They focused on domestic and global uncertainty, using the World Uncertainty Index (WUI) and the Economic Policy Uncertainty Index as well as the VIX as measures of risk.

Their initial results indicate that the effects of uncertainty depend on the country group, and therefore they disaggregated the data.  Domestic uncertainty does not appear to be a factor for any of the three groups, but global uncertainty as measured by the WUI has a large and significant negative impact on FDI in the advanced and emerging market economies.

The authors also examined the impact of global financial factors on FDI. They iniitally used the real value of the Standard & Poor’s 500 index, and report that an increase in that measure is linked to increases in FDI in the advanced economies but declines in the emerging market and developing economies. The higher returns in the U.S. draw funds away from those propsetive hosts.

Similarly, when they replace the S&P 500 with the nominal shadow Federal Funds rate or a world interest rate, they report that increases in either rate increased FDI in the advanced economies and lowered FDI flows in the developing economies. They suggest that this result reflects the existence of booms in the financial center countries that GDP data do not capture. They also reexamine the significance of the world uncertainty index as the different global financial variables are used, and find that the negative and significant impact holds up in the case of the emerging market economies.

Many types of risk, therefore, have an impact on FDI. Domestic financial risk in an origin country, for example, leads to less outward FDI by multinational firms based in that country. But firms are also affected by global uncertainty, and their response in terms of foreign investment seems to be most evident in the emerging market economies. Geopolitical tensions over the Ukraine,  the possibility of a new variant of the virus and the prospect of higher U.S. interest rates all reinforce global uncertainty and complicate the decision over where to locate new investments.

The Return of FDI

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Last year’s collapse in foreign direct investment was seen by many as the first stage of a period of retrenchment. Political pressure to “reshore” production, particularly of goods of national importance such as medical equipment, would cause multinational firms to rearrange their global supply chains to minimize foreign exposure. The data released for FDI in the first half of this year shows that in fact foreign investment has rebounded from last year’s decline. But the largest growth rates were recorded for the upper-income countries, where FDI had fallen precipitously in 2020, and China. FDI also rose in middle-income countries where it  had not fallen as sharply in 2020. Low income countries, on the other hand, did not see any increase in foreign investment.

The October issue of the Organization of Economic Cooperation and Development’s FDI In Figures reports that global FDI flows rose to $870 billion in the first half of 2021. These flows were more than double those of the last half of 2020 and even higher than pre-pandemic flows. The largest increase was recorded in China, the world’s major recipient of FDI. But the second and third largest inward flows were recorded in the U.S. and the U.K. FDI inflows to the Group of 20 economies increased by 42% in the first half of this year as compared to the previous half-year. They were up in 83% in the OECD G20 countries, and 12% in the non-OECD G20, reflecting a split by income level.

Earnings on inward OECD FDI increased by about 30% in the first half of the year, from the previous half-year. About half of this amount was distributed to affiliates and the remaining funds reinvested. Earnings on outward FDI increased by 28%, and a larger share of these payments were reinvested rather than distributed. Compared to pre-pandemic levels, these earnings were 14% higher. Growth in the earnings of outward FDI was particularly noticeable in the U.S., France, Germany, Japan, and the Netherlands, all home countries of multinational firms.

Much of the FDI activity in the OECD economies consisted of mergers and acquisitions (M&As), as both M&A deal values and the number of acquisitions rose in the advanced economies. Many of these deals were made in the healthcare and technology sectors. M&A activity in the emerging market and developing economies, however, was much less.

Investment in greenfield projects was relatively low compared to pre-pandemic levels. Announced greenfield projects increase by 9% in advanced economies but fell by 6% in the emerging market and development economies. Corporations are holding back from building new production facilities in those countries that saw large amounts of investment in the 1990s and early 2000s.

The difference in FDI activity amongst countries also appears in the October issue of UNCTAD’s  Investment Trends Monitor. It reports that FDI recorded growth rates of 117% in the high-income countries, 30% in the middle-income countries but a decline of 9% in the low-income group. The report cites “the duration of the health crisis and the pace of vaccinations, especially in developing countries” as “factors of uncertainty.”  This report also noted the decline in greenfield projects.

A similar discrepancy in national growth prospects was noted by the IMF in the latest issue of the World Economic Report. The report stated:

Advanced economy output is forecast to exceed pre-pandemic medium-term projections—largely reflecting sizable anticipated further policy support in the United States that includes measures to increase potential. By contrast, persistent output losses are anticipated for the emerging market and developing economy group due to slower vaccine rollouts and generally less policy support compared to advanced economies.

As noted above, China is a conspicuous exception to the FDI trends for emerging market and developing economies. Megan Greene of Harvard’s Kennedy School, in a column “Don’t Believe the Deglobalisation Narrative” in the Financial Times, interpreted the data on the inflows of FDI and other financial flows as showing that there isn’t any evidence of a corporate retreat from China. The country continues to offer modern infrastructure for the movement of parts and goods, domestic supplier networks and a large labor force. Moreover, China’s own markets represent potential sources of profits if consumption expenditures increase.

FDI may have rebounded from its downturn in 2020, but the increase in investment flows has been distributed unevenly. Part of the unequal allocation is due to the virus, with a new mutation appearing in some African countries. As long as the virus evolves into more virulent strains, there will always be the threat of another outbreak. Only a truly global effort that includes the delivery of vaccines to those nations most in need can stop the cycle and reorient foreign investment.

FDI and the Pandemic

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The fluctuations in portfolio capital flows to emerging markets over the past year have been well documented. But foreign direct investment (FDI) has also plunged in those countries as well as in the advanced economies. Moreover, FDI faces more long-term challenges than other forms of capital flows.

In October the Organization of Economic Cooperation and Development (OECD) reported FDI data for the first half of the year. The OECD found that global FDI flows fell by half in the first six months as compared to the second half of 2019. Inflows to the OECD area countries fell by 74%, driven by lower flows to the U.S. and reverse flows from Switzerland, the Netherlands and the United Kingdom. Outflows fell by 43%. FDI inflows to the non-OECD members of the Group of Twenty (G20) decreased by 30% and outflows decreased by 60%.

These declines followed a period of reduced FDI flows (see here and here). The OECD had reported in April that FDI flows in 2019 were below the levels recorded between 2010 and 2017. U.S.-based firms were reassessing their foreign operations in the wake of changes in the U.S. tax regulations governing the taxation of foreign profits. The tariffs imposed by the Trump administration on Chinese goods affected multinational activities in that country, while Chinese acquisitions of U.S. firms came under much stricter government scrutiny. Similarly, the vote in favor of Brexit forced firms to reconsider supply chains that linked the U.K. with the rest of Europe.

Pol Antrás of Harvard provides an insightful examination of the future of global supply chains in a recent NBER working paper, “De-Globalisation? Global Value Chains in the Post-Covid-19 Era.” He points out that rapid pace of globalization that began in the late 1980s and extended through the early 2000s was unsustainable, and that some slowdown was inevitable. The rapid expansion reflected the development of information and communication technology, as well as a fall in trade costs due to declines in government barriers as well as faster methods of shipping. He also cites the expansion of the global economy to include the former Communist countries, as well as the Asian countries that expanded the market-based sectors of their economies.

Could these developments be reversed? Antrás writes that while the impact of automation and 3D printing on globalization is unclear, there are digital technologies that may give a new impetus to trade and investment. Moreover, the economies of scale associated with global supply chains make their dismantling unlikely.

On the other hand, the policy and institutional factors that fueled the previous expansion of globalization could come to a halt or be reversed. Antrás attributes the fall in support for international trade to its impact on income distribution. While technology and other factors have contributed to the rise in inequality, there is sufficient evidence that trade integration has been a factor as well. Recent studies have linked support for protectionist measures to trade-induced inequality.

Antrás also provides some conjectures about the consequences of COVID-19 on globalization. Once the pandemic is behind us, international travel will most likely be more expensive, and this may affect the initiation of new enterprises, although the increased use of technology to provide contacts between people may offset that effect. On the other hand, the political response to the pandemic threatens to exacerbate already existing tensions between China and the U.S., and could lead to a global partition. Moreover, the cost of the pandemic has been borne disproportionately by low-wage earners, and any increase in inequality will further weaken support for global trade.

The pandemic heightened the awareness of global supply chains, and last spring there was a great deal of discussion of “reshoring,” i.e., bringing foreign operations back to the home countries of multinationals.  The Economist reports that to date there is little sign that U.S. firms are replacing operations in other countries with domestic production. However, the article points out that the expansion of global production networks was based in part on the belief that governments would not hamper their activities since interference would hurt importers and exporters. But recent events have shown that political divisions can affect trade policy in unexpected ways. The steps that the Biden administration to reengage with international agencies, such as the World Trade Organization, and trade partners, particularly China, will be carefully watched.

FDI in a Risky World

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The pandemic has shown that global supply chains are vulnerable to shocks. Output contracted as factories were closed in China and the impact was transmitted to firms further along the chains and the distributors of the final goods. Foreign direct investment had already slowed in the aftermath of the global financial crisis of 2008-09, and there were questions about its future (see here). How will multinational firms respond to the new shock?

The McKinsey Global Institute seeks to answer this question in a new report, Risk, Resilience and Rebalancing In Global Value Chains. The authors point out that the pandemic is only one of a range of shocks that can disrupt production. They distinguish between catastrophes that are foreseeable (such as financial crises) and those unanticipated (acts of terrorism), as well as disruptions that take place on a smaller scale. The latter can also be divided between those that are foreseeable (climate change) and those that are unanticipated (cyberattacks).

The report then measures the exposure of different business sectors to the various shocks. Those that are heavily traded are more vulnerable. These include communication equipment, computers and electronics, and semiconductors and components, all industries that are seen as promoting growth. Apparel is another sector that is vulnerable to risks, such as the pandemic and climate change.

These risks will motivate firms to reconfigure their supply chains. The political fissure between China and the U.S., as well as government policies to ensure self-sufficiency in some sectors, will also induce firms to reorganize production. The report’s authors estimated that 16% to 26% of current exports could be shifted. They find that “…the value chains with the largest potential to move production to new geographies are petroleum, apparel, and pharmaceuticals.” In some cases governments may need to provide financial support to induce firms to relocate to domestic economies where the governments seek domestic self-sufficiency.

The United Nations Conference on Trade and Development (UNCTAD) in its World Investment Report 2020 also considers the future of FDI (see here for a summary). It identifies three trends that will shape the future of international production. These include technology trends that contribute to a “New Industrial Revolution;” growing nationalism that leads to more protectionism; and the need to achieve sustainability.  As these forces evolve, they will push firms to increase supply chain resilience and increase national and regional productive ability.

The authors of the UNCTAD point out that economic sectors differ in terms of the length of their existing value chains, their geographical distribution and their governance. Consequently, multinational firms will respond in different ways to the trends the authors identify. But they identify three overall trajectories–reshoring, regionalization and replication–that all involve scaling down global value chains. A fourth trajectory–diversification–would transform existing operations but include a lower geographical distribution of value added and less investment in capital goods.

These changes represent challenges to government policymakers, particularly those in developing economies. A retreat of international production will hamper the prospects of lower-income countries where the global supply chains have been a driver of growth. But there is also the opportunity to attract new investment. Among the measures that the report’s authors recommend are investment promotion strategies in infrastructure and services, and participation in regional initiatives.

The reconfiguration if international production systems will shape FDI in the years to come. But the formation of new production chains will only take place as the global economy recovers from the current collapse. UNCTAD reports that global FDI flows are forecast to fall by up to 40% in 2020 from their 2019 value of $1.54 trillion, and could decline by another 5% to 10% in 2021. All these predictions come with large degrees of uncertainty about the future of the global economy. Multinational firms will hold back on new expenditures until they see a consistent recovery and learn how governments will seek to influence their foreign operation.

Is There a Future for FDI?—Update

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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?

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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.

The Changing Nature of FDI

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The OECD has published its data on flows of foreign direct investment (FDI) for the first half of 2019. They reveal how multinational firms are responding to the slowdown in global trade and the U.S.-Chinese tariffs. They may also reflect longer-term trends in FDI as multinationals reconfigure the scope of their activities.

Overall global FDI flows fell by 20% in the first half of the year as compared to the previous half-year. Much of the decrease was due to lower investments in the OECD economies, including the U.S., the United Kingdom, and the Netherlands, and disinvestments in Belgium and Ireland. FDI inflows to the non-OECD members for the Group of 20 countries, on the other hand, increased, with higher investments recorded in Russia, China and India.

Some of the decline can be linked to the slowdown in international trade. The World Trade Organization forecasts growth in trade this year of 1.2%, the weakest since 2009, and lower than the IMF’s expected global economic growth of 3%. But the disinvestment in Belgium and other countries may also be due to the decline in the use of Special Purpose Entities for routing FDI through low-tax jurisdictions before reaching their ultimate destination. The OECD has sought to limit the spread of Base Erosion and Profits Shifting (BEPS) activities.

The OECD also reported a large drop in Chinese FDI in the U.S., from a peak of $14 billion in the second half of 2016 to less than $1.2 billion. The decline shows the impact of the tariffs imposed by the U.S. and Chinese governments, as well as the overall uncertainty of relations between the two countries. Moreover, the Chinese government has cracked down on outward FDI while the U.S. government scrutinizes Chinese acquisitions more carefully.

The changes in the allocation of FDI may also reflect longer-run factors in the development of global supply (or value) chains. Multinational firms used information and communications technology in the 1990s and 2000s to organize production on a worldwide bases, linking together suppliers and assembly plants in many countries. The OECD has estimated that about 70% of global trade now involves such chains.

Koen De Backer and Dorothée Flaig of the OECD wrote about some of the developments that could affect these chains over time in an OECD Policy Paper, “The Future of Global Value Chains: Business As Usual or “A New Normal’?” They point to a number of factors that could contribute to the continuing expansion of global chains. These include cheaper telecommunications, the emergence of new host countries, and the growth in economics services, including the coordination of the activities of value chains. But there are other factors that may slow the growth of global supply chains, such as the increasing costs of production (particularly wages) in some emerging markets and growing public pressure on firms to lower their use of natural resources, such as energy-related expenditures for transportation.

Another factor that could limit the expansion of multinationals is the advance of information technologies. These include robotics, artificial intelligence and 3-D printing, which would offset the advantages of low-cost wages in developing economies and provide an incentive to return production to the advanced economies. In addition, all these methods may allow firms to produce customized products for local needs that do not need global distribution networks.

The authors use the OECD’s Metro model to estimate the impact of these different factors on global value chains (GVCs). They find that overall the “…negative impacts on GVCs are found to be larger than the positive impacts, thereby suggesting that “A new normal” is developing for GVCs.” In particular, they report that “…the digitalisation of production is most likely the biggest game-changer for the future of GVCs…The growing importance of information technologies like robotics, artificial intelligence, automation, etc. will significantly redraw the contours of the global economy and have a disruptive impact on GVCs.”

In addition to these long-term developments, host and home country governments are less encouraging of multinationals than they have been in the past. The Economist (“The Retreat of the Global Company”, 1/28/2017) reports that home countries are concerned about a loss of jobs and a fall in tax revenues due to BEPS. President Donald Trump has made clear his desire for U.S.-based firms to produce domestically. The host countries of emerging markets are more welcoming to multinational expansion, but they also seek jobs that may not be forthcoming if much of the growth of the multinationals is based on services rather than manufacturing. Moreover, these governments place limits on what digital firms are allowed to do in their jurisdictions and they seek to encourage domestic competitors.

The future of foreign direct investment, therefore, is in flux. Part of this reflects uncertainty due to current economic and political trends. But there are also longer-term developments that may reshape the nature of the cross-border expansion of the multinational firms that took place between the 1990s and 2008. Multinationals will continue to play an important role in the global economy, but their activities may be less encompassing as they have been, and this will affect FDI flows.

The Rise and Fall of FDI

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After the global financial crisis,  international capital flows contracted, especially bank lending in Europe. Foreign direct investment (FDI) by multinational firms, however, provided a steady source of external finance, particularly for emerging market economies. The McKinsey Global Institute has calculated that the global stock of FDI increased from 46% of world GDP in 2007 to 57% in 2016 ($25 trillion to $41 trillion). But FDI flows fell by 27% in 2018 according to the Organization of Economic Cooperation and Development (OECD), and this drop followed a decline of 16% in the previous year. We have entered a new period of contraction by multinational firms, and in particular, U.S.-based multinationals.

A significant amount of the decline is due to firms based in the U.S. responding to changes in U.S. tax law. The U.S.-based firms repatriated earnings that had been kept abroad to avoid U.S. taxes. As a result, the U.S. recorded a negative FDI outflow of $50 trillion in 2018, down from a positive outflow of $379 billion in the previous year. By the latter half 2018, the acquisition of foreign assets had returned to positive levels, but the long-run changes of the tax code revision on the foreign operations of U.S. firms will only become clear over time.

Ireland and Switzerland were particularly hard-hit by the disinvestments, since these countries had often attracted FDI because of generous tax provisions. There were also reversals of investment in Special Purpose Entities (SPE), which allow the multinationals to channel funds through countries with favorable regulatory and tax practices to their ultimate destination. The OECD reported that FDI flows to SPEs in Luxembourg and the Netherlands fell to negative levels last year.

But the alteration in U.S. tax law is only part of a wider change in policy in the U.S.  President Trump seeks to undo expansion by multinationals by persuading U.S. firms to return their operations to the U.S. During the last several decades, these firms and other multinationals used technological advances in communication and transportation to establish global supply chains of production. They located the production of intermediate goods in those countries where they were cheapest to produce before assembling them and exporting them to their final markets.

This expansion was facilitated by the establishment of stable macroeconomic and political conditions in the host countries where the production facilities were located. In many cases, these were emerging market nations, and their governments welcomed the investments of the multinationals, as the firms hired local labor and transferred capital and technology. Singapore, for example, has used its position as a financial hub and its reputation for pro-business regulatory policies to become a major recipient of FDI flows.

The establishment of production facilities in different countries has benefits and costs for home and host countries. But President Trump views this expansion only through the criterion of its impact on U.S. jobs, and he sees losses. He wants the U.S. firms to base their production in the U.S. where they will hire American workers. The President has frequently claimed that his use of tariffs and other tactics will re-establish manufacturing in the U.S.

Some U.S. firms were already responding to higher costs in China by shifting their supply chains elsewhere. But they often switch their operations to Vietnam and other low-wage countries, not the U.S. A policy of nationalism that forced firms to only operate here would require massive expenditures and higher costs for consumers. It would affect the ability of U.S. firms to export, since our exports often contain foreign components.

The Trump administration’s hostility to trade and outward FDI also affects inward FDI by foreign multinationals. These firms are often courted by state governments that want the high-paying jobs that they provide. Theodore H. Moran and Lindsay Oldenski of the Peterson Institute for International Economics and Georgetown’s School of Foreign Service have calculated that in 2013 the wages paid to the U.S. employees of foreign-owned multinationals exceeded those of U.S. workers of U.S. multinationals, which in turn exceeded those paid to workers in all firms by more than 10%. The U.S. and foreign multinationals accounted for 30 million workers, who in 2013 represented 22% of all jobs in the U.S.

But foreign firms have cut down on further expansion in the U.S.  Foreign capital inflows to the U.S. fell from $509 billion in 2015 to $267 billion in 2018. Some of this downturn may have been cyclical, but foreign firms also have to consider the effect of tariffs on U.S. production. Adam Posen of the Peterson Institute for International Economics has warned “…that this shift of corporate investment away from the U.S. will decrease long-term U.S. income growth, reduce the number of well-paid jobs available, and accelerate the shift of global commerce away from the U.S.”

The decline in FDI last year reflected other factors than U.S. policy measures. While 2018 initially was characterized as a period of widespread growth, this expansion slowed during the year in response to instability in Turkey and Argentina, credit tightening in China, and other developments. This global slowdown in growth is expected to persist and the IMF forecasts economic growth in 2019 of 3.3%, down from 3.6% in 2018.

There is evidence that the rapid pace of expansion of the pre-global crisis has come to an end. The return on equity of multinationals has fallen from its pre-crisis peak. The ability of firms such as Apple to continue to post continued growth in global sales is being questioned. Governments such as India’s seek to protect domestic firms from foreign competition. Moreover, as pointed out above, China no longer is a source of cheap labor, and firms need to adapt to changing cost structures.

The immediate impact of the change in the U.S. tax provisions on FDI has most likely ended. But the fall-off in corporate expansion over the last two years is also a response to the changes in international trade and finance. The Trump administration has made clear that it wants to reverse the globalization of recent years, and the imposition of tariffs on Chinese and other goods will lead to a reorientation of business models. Over time this may be seen as the last gasp of a reactionary regime that was reversed under a future president. But the President’s Democratic challengers seem equally reluctant to support trade and expansion by U.S. firms. Until the status of trade in the global economy is clarified, multinationals will be reluctant to commit to foreign expansion.