I have written a piece on international factor payments (migrants’ remittances, FDI income) and the pandemic for Econbrowser, the widely followed blog of Menzie Chinn of the University of Wisconsin and James Hamilton of the University of California-San Diego.
You can find it here:
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.
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.
After the 2008-09 global financial crisis, economists were criticized for not predicting its coming. This charge was not totally justified, as there were some who were concerned about the run-up in asset prices. Robert Schiller of Yale, for example, had warned that housing prices had escalated to unsustainable levels. But the looming debt crisis in the emerging market economies has been foreseen by many, although the particular trigger—a pandemic—was not.
Last year the World Bank released Global Waves of Debt: Causes and Consequences, written by M. Ayhan Kose, Peter Nagle, Franziska Ohnsorge and Naotaka Sugawara. The authors examined a wave of debt buildup that began in 2010. By 2018 total debt in the emerging markets and developing economies (EMDE) had risen by 54 percentage points to 168% of GDP. Much of this increase reflected a rise in corporate debt in China, but even excluding China debt reached a near-record level of 107% of GDP in the remaining countries.
The book’s authors compare the recent rise in the EMDE’s debt to other waves of debt accumulation during the last fifty years. These include the debt issued by governments in the 1970s and 1980s, particularly in Latin America; a second wave from 1990 until the early 2000s that reflected borrowing by banks and firms in East Asia and governments in Europe and Central Asia; and a third run-up in private borrowing via bank loans in Europe and Central Asia in the early 2000s. All these previous waves ended in some form of crisis that adversely affected economic growth.
While the most recent increase in debt shares some features with the previous waves such as low global interest rates, the report’s authors state that it has been “…larger, faster, and more broad-based than in the three previous waves…” The sources of credit shifted away from global banks to the capital markets and regional banks. The buildup included a rise in government debt, particularly among commodity-exporting countries, as well as private debt. China’s private debt rise accounted for about four-fifths of the increase in private EMDE debt during this period. External debt rose, particularly in the EMDEs excluding China, and much of these liabilities were denominated in foreign currency.
The World Bank’s economists report that about half of all episodes of rapid debt accumulation in the EMDEs have been associated with financial crises. They (with Wee Chian Koh) further explore this subject in a recent World Bank Policy Research Paper, “Debt and Financial Crises.” They identify 256 episodes of rapid government debt accumulation and 263 episodes of rapid private debt accumulation in 100 EMDEs over the period of 1970-2018. They test their effect upon the occurrence of bank, sovereign debt and currency crises in an econometric model, and find that such accumulations do increase the likelihood of such crises. An increase of government debt of 30 percentage points of GDP raised the probability of a debt crisis to 2% from 1.4% in the absence of such a build-up, and of a currency crisis to 6.6% from 4.1%. Similarly, a 15% of GDP rise in private debt doubled the probability of a bank crisis to 4.8% if there were no accumulation, and of a currency crisis to 7.5% from 3.9%. (For earlier analyses of the impact of external debt on the occurrence of bank crises see here and here.)
Kristin J. Forbes of MIT and Francis E. Warnock of the University of Virginia’s Darden Business School looked at episodes of extreme capital flows in the period since the global financial crisis (GFC) in a recent NBER Working Paper, “Capital Flows Waves—or Ripples? Extreme Capital Flow Movements Since the Crisis.” They update the results reported in their 2012 Journal of International Economics paper, in which they distinguished between surges, stops, flights and retrenchments. They reported that before the GFC global risk, global growth and regional contagion were associated with extreme capital flow episodes, while domestic factors were less important.
Forbes and Warnock update their data base in the new paper. They report that has been a lower incidence of extreme capital flow episodes since 2009 in their sample of 58 advanced and emerging market economies, and such episodes occur more as “ripples” than “waves.” They also find that as in the past the majority of episodes of extreme capital flows were debt-led. When they distinguish between bank versus portfolio debt, their results suggest a substantially larger role for bank flows in driving extreme capital flows.
Forbes and Warnock also repeat their earlier analysis of the determinants of extreme capital flows using data from the post-crisis period. They find less evidence of significant relationships of the global variables with the extreme capital flows. Global risk is significant only in the stop and retrenchment episodes, and contagion is significantly associated only with surges. They suggest that these results may reflect changes in the post-crisis global financial system, such as greater use of unconventional tools of monetary policy, as well as increased volatility in commodity prices.
Corporations can respond to crises by changing how and where they raise funds. Juan J. Cortina, Tatiana Didier and Sergio L. Schmukler of the World Bank analyze these responses in another World Bank Policy Research Working paper, “Global Corporate Debt During Crises: Implications of Switching Borrowing across Markets.” They point out that firms can obtain funds either via bank syndicated lending or bonds, and they can borrow in international or domestic markets. They use data on 56,826 firms in advanced and emerging market economies with 183,732 issuances during the period 1991-2014, and focus on borrowing during the GFC and domestic banking crises. They point out that the total amounts of bonds and syndicated loans issued during this period increased almost 27-fold in the emerging market economies versus more than 7 times in the advanced economies.
Cortina, Didier and Schmukler found that the issuance of bonds relative to syndicated loans increased during the GFC by 9 percentage points from a baseline of 52% in the emerging markets, and by 6 percentage points in the advanced economies from a baseline probability of 28%. There was also an increase in the use of domestic debt markets relative to international ones during the GFC, particularly by emerging economy firms. During domestic banking crises, on the other hand, firms turned to the use of bonds in the international markets. When the authors used firm-level data, they found that this switching was done by larger firms.
The authors also report that the debt instruments have different characteristics. For example, the emerging market firms obtained smaller amounts of funds with bonds as compared to bank syndicated loans. Moreover, the debt of firms in emerging markets in international markets was more likely to be denominated in foreign currency, as opposed to the use of domestic currency in domestic markets.
Cortina, Didier and Schmukler also investigated how these characteristics changed during the GFC and domestic bank crises. While the volume of bond financing increased during the GFC relative to the pre-crisis years, syndicated bank loan financing fell, and these amounts in the emerging market economies fully compensated each other. In the advanced economies, on the other hand, total debt financing fell.
The global pandemic is disrupting all financial markets and institutions. The situation of banks in the advanced economies is stronger than it was during the GFC (but this could change), and the Federal Reserve is supporting the flow of credit. But the emerging markets corporations and governments that face falling exports, currency depreciations and enormous health expenditures will find it difficult to service their debt. Kristalina Georgieva, managing director of the IMF, has announced that the Fund will come to the assistance of these economies, and next week’s meeting of the IMF will address their needs. The fact that alarm bells about debt in emerging markets had been sounding will be of little comfort to those who have to deal with the collapse in financial flows.
Explaining the sources and destinations of capital flows is a key focus of research in international finance. But capital flows between countries can flow through financial centers before they arrive at their ultimate destination, and these intermediary flows distort the record of the actual ownership of investments. Two recent papers seek to provide a more accurate picture of the true sources of foreign finance.
Jannick Damgaard of Danmarks Nationalbank, Thomas Elkjaer of the International Monetary Fund and Niels Johannesen of the University of Copenhagen differentiate between “phantom” and “real” foreign direct investment in their 2019 IMF working paper, “What Is Real and What Is Not in the Global FDI Network?” Phantom FDI flows to shell companies that do not engage in any business activities, and are used to minimize corporate taxation before the funds are channeled to their final destination. Among the host countries that receive a significant amount of phantom investment are the Netherlands, Luxembourg, Hong Kong, Switzerland, Singapore and Ireland. The phantom FDI overstates the actual amount of investment that takes place and obfuscates the ultimate ownership of foreign capital.
Damgaard, Elkjar and Johannsen use several sources of data in order to uncover the actual owners of FDI. These include the IMF’s Coordinated Direct Investment Survey, which reports foreign investments in 110 countries by the country of the immediate owner; the OECD’s Foreign Direct Investment Statistics, which differentiates between FDI in Special Purpose Entities (SPEs), a form of shell company, and non-SPE investment, and also includes information on the ultimate owners of investment; and Orbis, a global database of corporate data, including ownership information. Since the OECD data are incomplete, they estimate the share of real FDI in total FDI by using the negative relationship of real FDI/total FDI and total FDI/GDP.
Their results show that in 2017 global FDI of almost $40 trillion included real FDI of $25 trillion and phantom FDI of about $15 trillion. Moreover, the share of phantom FDI in total FDI has risen from above 30% in 2009 to just below 40% in 2017. Luxembourg reported the largest amount of phantom FDI of $3.8 trillion, followed by the Netherlands with around $3.3 trillion. The largest stock of real FDI, on the other hand, was located in the U.S., which also owned the largest amount of outward FDI. China has been a significant recipient of inward FDI (but see below), as were the United Kingdom, Germany and France. The authors also found evidence of “round tripping,” i.e., supposedly inward foreign investment that is actually held by domestic investors. In the case of China and Russia about 25% of real FDI is owned by investors in those countries.
Another investigation of the data on international capital was undertaken by Antonio Coppola of Harvard, Matteo Maggiori of Stanford’s Graduate School of Business, Brent Neiman of the University of Chicago’s Booth School of Business and Jesse Schreger of the Columbia Business School, and they report their results in “Redrawing the Map of Global Capital Flows: The Role of Cross-Border Financing and Tax Havens.” Global firms have increasingly issued securities through affiliates in tax haven, and these authors seek to uncover the ultimate issuers of these securities. Their results allow them to distinguish between data reported on a “residency” basis based on the country where the securities are issued versus a “nationality” basis, which shows the country of the ultimate parent.
The authors begin with data from several databases that allows them to uncover global ownership chains of securities through tax haven nations such as Luxembourg and the Cayman Islands. They use this mapping to determine the ultimate issuers of securities held by mutual funds and exchange traded fund shares that are reported by Morningstar. Finally, they use their reallocation matrices to transform residency-based holdings of securities as reported in the U.S. Treasury’s International Capital data and the IMF’s Coordinated Portfolio Investment Survey to nationality-basis holdings.
Their results lead to a number of important findings. Investments from advanced economies to emerging market countries, for example, have been much larger than had been reported. For example, U.S. holdings of corporate bonds in the BRIC economies (Brazil, Russia, India and China) total $99 billion, much larger than the $17 billion that appears in the conventional data. U.S. holdings of Chinese corporate bonds alone rises from $3 billion to $37 billion, and of Brazilian bonds the total increases from $8 billon to $44 billion. These figures are even higher when the U.S. subsidiaries of corporations in emerging markets which issue securities in the U.S. are accounted for. Similarly, holdings of common equities in the emerging markets by investors in the U.S. and Europe are much larger when the holdings are reallocated from the tax havens to the ultimate owners. This is particularly evident in the case of China.
The reallocation also shows that the amount of corporate bonds issued by firms in the emerging markets has been more significant than realized. While the issuance of sovereign bonds is accurately reported, the issuance of corporate bonds has often occurred via offshore subsidiaries. These bonds are often denominated in foreign currencies, so their reallocation to their ultimate issuers results in an increase in foreign currency exposure for their home countries.
As in the previous study, Coppla, Maggiori, Neiman and Schreger also find that some “foreign” investment represents domestic investment routed through a tax haven, such as the Cayman Islands. These flows are particularly significant in the case of the U.S. In addition, some FDI flows to China should be classified as portfolio, since they reflect foreign participation in offshore affiliates that is channeled to China. FDI positions are not revalued as often as portfolio holdings, and as a result the authors claim that China’s net foreign asset position is overstated.
The results of these ground-breaking papers have important implications. First, the international ownership of capital is more concentrated than realized. The “Lucas paradox” of international capital flowing from developing to advanced economies was based on misleading data. The U.S. and several other advanced economies have large stakes in the emerging markets. Second, some of emerging markets are more vulnerable to currency depreciations than the official data suggest because their corporations have issued debt through subsidiaries in ta haven countries. Third, multinational corporations have been successful in shielding their income from taxation by using tax havens. The OECD has been working to bring this profit shifting under control, but effective reform may require a fundamental change in how multinationals are taxed by national governments.
The spillover of U.S. monetary policy on foreign economies has become an active area of research. Analysts seek to identify the channels of transmission between the policy stance of the Federal Reserve and foreign interest rates and credit extension. The usual account is that an expansionary Fed policy leads to capital outflows and an appreciation of foreign currencies as investors seek higher yields abroad. Two recent papers have focused on different aspects of this linkage.
Silvia Albrizio of the Bank of Spain, Sangyup Choi of Yonsei University, Davide Furceri of the IMF and Chansik Yoon of Princeton University investigated the impact of monetary tightening on cross-border bank lending in an IMF working paper, “International Bank Lending Channel of Monetary Policy.” Previous work was divided on whether a contractionary U.S. policy would lead to a decline or an increase in international bank lending. These economists used data on exogenous policy shocks in the U.S., which are based on the narrative approach of Romer and Romer (2004), to examine their impact on cross-border bank lending in 45 countries.
The results show clear signs of a significant negative effect of U.S. monetary policy shocks on cross-border lending. A 100 basis point rise in the policy rate leads to a sizable more than 10% fall in lending after two quarters. When the authors extended their analysis to include monetary policy shocks in Canada, Germany, Italy, Japan, the Netherlands, Spain, Sweden and the U.K., they again found that exogenous monetary tightening in these economies led to a decline in cross-border bank lending. These results hold even when the authors control for global uncertainty or liquidity risks.
Sebnem Kalemli-Özcan of the University of Maryland focused on the impact of U.S. monetary policy changes on risk in her 2019 Jackson Hole presentation, “U.S. Monetary Policy and International Risk Spillovers.” In her analysis, there are two components of risk, global risk and country-specific risk, and these are crucial elements in the transmission of changes in U.S. policies to the emerging market economies. In these countries, a tightening of U.S. monetary policy leads to a rise in global risk as well as an increase in country risk. These changes in the risk premia affect the domestic response to the U.S. policy. The advanced economies, on the other hand, do not show similar responses.
For example, in the empirical analysis Kalemli-Özcan finds that an increase in the U.S. Treasury rate leads to an increase in the differential with domestic government bond rates in her sample of 46 emerging market economies, but a decline in the same differential in her sample of 13 advanced economies. However, the differential in the emerging market countries falls when a measure of global risk aversion (VIX) is added to the analysis, and becomes insignificant when an indicator of country risk (Emerging Market Bond Index Global of JPMorgan) is also utilized.
Risk premia also affect the linkage of domestic policy rates and lending rates. The presence of risk injects a wedge between the two domestic interest rates. If domestic bank rates are regressed on the policy rate in the emerging markets, the pass-through is less than complete, whereas the pass-through is almost complete in the case of the advanced economies. But the impact in the emerging markets rises when the two indicators of risk are included in the empirical analysis.
Kalemli-Özcan infers that the central banks of the emerging markets loosen their policies when risk rises, and tighten when risk falls. This response is determined in part by the type of exchange rate regime that a country has. Those emerging markets that manage their exchange rates raise their policy rates in response to the increased risk premia following a U.S. tightening. These interest rate upswings in turn affect domestic economic activity. A flexible exchange rate regime, on the other hand, mitigates the undesirable effects of the risk spillovers by absorbing the response to the higher risk. The differences in exchange rate regimes, therefore, may explain the divergence in the responses of emerging market and advanced economies to U.S. policy shocks.
Both papers acknowledge that U.S. policies have significant effects on foreign economies. Albrizio, Choi, Furceri and Yoon conclude that U.S. monetary policy is a contributor to the “global financial cycles” that Rey (2015) and others have identified. Kalemli-Özcan finds that U.S. policies are a “powerful force in driving international risk spillovers.” While global trade flows may have fallen, capital flows until the coronavirus were robust. As long as the U.S. dollar is dominant in international commerce and finance, the Fed’s influence will continue to unsettle foreign nations.
It has been a decade since the global financial crisis effectively ended opposition to the use of capital controls. The IMF’s drive towards capital account deregulation had been blunted by the Asian financial crisis of 1997-98, but there was still a belief in some quarters that complete capital mobility was an appropriate long-run goal for emerging markets once their financial markets sufficiently matured. The meltdown in financial markets in advanced economies in 2008-09 ended that aspiration. Several recent papers have summarized subsequent research on the justification for capital controls and the evidence on their effectiveness.
Bilge Erten of Northeastern University, Anton Korinek of the University of Virginia and José Antonio Ocampo of Columbia University have a paper, “Capital Controls: Theory and Evidence,” that was prepared for the Journal of Economic Literature and summarizes recent work on this topic. In this literature, the micro-foundations for the use of capital controls to improve welfare are based on externalities that private agents do not internalize. The first type of externality is pecuniary, which can lead to a change in the value of collateral and a redistribution between agents. In such cases, private agents may borrow more than is optimal for society, which suffers the consequences in the event of a financial shock. Policymakers can restrict capital flows to limit financial fragility.
The second justification of capital controls is due to aggregate demand externalities, which are associated with unemployment. Private agents may borrow in international markets and fuel a domestic boom that leaves the domestic economy vulnerable to a downturn. If there are domestic frictions and constraints on the use of monetary policy that limit the response to an economic contraction, then capital controls may be useful in mitigating the downturn.
Alessandro Rebucci of Johns Hopkins and Chang Ma of Fudan University also summarize this literature in “Capital Controls: A Survey of the New Literature,” prepared for the Oxford Research Encyclopedia of Economics and Finance. They discuss the use capital controls in the case of both pecuniary and demand externalities, and capital controls in the context of the trilemma. In their review of the empirical literature on capital controls, they summarize two lines of research. The first deals with the actual use of capital controls, and the second their relative effectiveness.
Whether or not capital controls are used as a countercyclical instrument together with other macroprudential tools has been an issue of dispute. Rebucci and Ma report there is recent evidence that indicates that such instruments have been utilized in this manner, as the recent theoretical literature proposes. There are also cross-country studies of capital control effectiveness that are consistent with the theoretical justification for the use of such measures. For example, capital controls can limit financial vulnerability by shifting the composition of a country’s external balance sheet away from debt.
Some recent papers from the IMF investigate the actual use of capital controls and other policy tools in emerging market economies. Atish R. Ghosh, Jonathan D. Ostry and Mahvash S. Qureshi of the IMF investigated the response of emerging markets to capital flows in a 2017 working paper, “Managing the Tide: How Do Emerging Markets Respond to Capital Flows?” They report that policymakers in a sample of 51 countries over the period of 2005-13 used a number of instruments to deal with capital flows. In addition to foreign exchange market intervention and central bank policy rates, capital controls were utilized, particularly when the inflows took the form of portfolio and other flows. Tightening of capital inflow controls was more likely during periods of credit growth and real exchange rate appreciation. The authors’ finding that several major emerging markets have used capital controls to deal with risks to financial and macroeconomic stability is consistent with the theoretical literature cited above. However, the authors caution that their results do not indicate whether managing capital flows actually prevents or dampens instability.
This subject has been addressed by Gaston Gelos, Lucyna Gornicka, Robin Koepke, Ratna Sahay and Silvia Sgherri in their new IMF working paper, “Capital Flows at Risk: Taming the Ebbs and Flows.” They examine the policy responses to sharp portfolio flow movements in 35 emerging market and developing economies during the 1996-2018 period, using a rise in BBB-rated U.S. corporate bond yields as a global shock. The authors look at the structural characteristics and policy frameworks of the countries as well as their policy actions. Among their results they find that more open capital accounts at the time of the shock are associated with fewer large inflows after the shock. Moreover, a tightening of capital flow measures is linked to larger outflows in the short-run. They also find that monetary and macroprudential policies have limited effectiveness in shielding countries from the risks associated with global shocks.
Capital controls have become an important tool for many developing economies, and there are ample grounds to justify their implementation. Recent empirical literature seems to show that the actual implementation of such measures is undertaken in a manner that meets the criteria outlined in the theoretical literature. However, whether regulatory limits on capital mobility actually achieve their financial and macroeconomic goals is still not proven. The Federal Reserve has signaled its intention to maintain the Federal Funds Rate at its current level, but shocks can come from many sources. Policymakers may find themselves drawing upon all the tools available to them in the case of a new global disruption to capital flows.
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.
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.
My paper, “Partners, Not Debtors: The External Liabilities of Emerging Market Economies,” has been published in the January 2019 issue of the Journal of Economic Behavior & Organization.
Here is the abstract:
This paper investigates the change in the composition of the liabilities of emerging market countries from primarily debt (bonds, bank loans) to equity (foreign direct investment, portfolio) in the decades preceding the global financial crisis. We examine the determinants of equity and debt liabilities on external balance sheets in a sample of 21 emerging market economies and 20 advanced economies over the period of 1981-2013. We include a new measure of domestic financial development that allows us to distinguish between financial institutions and financial markets. Our results show that countries with higher economic growth rates have larger amounts of equity liabilities. The development of domestic financial markets is also linked to an increase in equity liabilities, and in particular, portfolio equity. In addition, larger foreign exchange reserves are associated with larger amounts of portfolio equity. FDI liabilities are more common when domestic financial institutions are not well developed.
The publisher, Elsevier, provides a link to provide free access to the paper for 50 days. You can find it here:
https://authors.elsevier.com/a/1YoqV_3pQ3g~6e