Tag 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.

China’s Missing Income

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The earnings of a country’s multinational firms appear in its balance of payments in the primary income component of the current income balance. Primary income includes the net flow of income received for the provision of a factor of production, such as labor, financial or other assets, to and from nonresidents. Investment income is usually the largest component of these income flows, and income from FDI appears there with income from portfolio and other types of investments (such as banks) as well as income from the central bank’s reserves.

The countries with the largest net flows of foreign direct investment income in 2021 were:

U.S.                    $348.9 billion

Japan                 $95.4 billion

Germany           $90.4 billion

France               $54.1 billion

Netherlands    $34.7 billion

U.K.                  $25.6 billion

(The Netherlands data exclude income flows associated with Special Purpose Entities, which serve as conduits for FDI flows.)

The ranking of countries by FDI income receipts can be compared with the listing of countries by the number of multinational firms with headquarters located in their borders. Pizzola, Carroll and Mackie (2020) of Ernst & Young provide a ranking of countries by the number of Fortune Global 500 firms headquartered in their jurisdictions. The U.S., Japan, France, Germany and the U.K. all appear at the top of the list. But the country at the number one position with the largest number of multinationals is China. Why doesn’t China also appear in the list of top FDI recipients?

There are several answers. First, China does not report the values of the components of its primary income, so we do not know what its net FDI income is. But it does report total net primary income, and that balance has almost always been negative. If FDI income is the largest component of primary income as it is for many other emerging market countries, then it has been contributing to the primary income deficit.

Second, while China is a net creditor nation with an overall net international investment position in 2021 of $2.2 trillion, its direct investment assets are less than its liabilities: $2.79 trillion vs $3.60 trillion, or net $ -0.82 trillion, according to the IMF’s Balance of Payments data. Similarly, while China has become a major source of FDI outflows, FDI inflows are larger: $178.8 billion in the acquisition of assets vs. $344.1 in the acquisition of liabilities in 2021. As long as investments into China exceed its own foreign acquisitions, the flow of income derived from these activities will be negative.

Brad Setser of the Council of Foreign Relations has also written about China’s primary account. He is puzzled by is decline in the decline in the balance in the second quarter of 2022 at a time when foreign holdings of Chinese bonds were falling. He also writes that:

“China was locked down and its economy shrank—not an ideal environment for foreign firms to make large profits.”

Pizzola, Carroll and Mackie point out that the headquarters of the multinational firms have over time shifted away from the U.S. and other members of the Group of 7 nations (Canada, France, Germany, Italy, Japan, U.K., U.S.) While the U.S. still accounts for the second largest number of headquarters, its total declined between 2000 and 2020. Japan also registered a decline in the number of multinational firms headquartered there. As other counties become the headquarters of multinational firms, their FDI income receipts will rise as well

The primary account balance plays an important role in many countries’ current accounts. In China, for example, in 2022 the surplus in the current account of $401.9 billion was smaller than the trade balance surplus of $576.3 billion because of the deficit in the primary account of  $193.6 billion. (Secondary income, which includes remittances, registered a surplus of $19.1 billion.)  It would be useful to have the full data on primary income to understand what is driving this component of China’s balance of payments.

The Costs of the Defragmentation of the Global Economy

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The integration of markets across borders has slowed down, and in some cases, reversed. These changes come in the wake of the global financial crisis, Donald Trump’s embrace of trade restrictions, Great Britain’s withdrawal from the European Union, the disruptions in global supply chains during the pandemic, and the invasion of Ukraine. President Biden has shown a willingness to use trade and financial restrictions in response to what he views as Chinese and Russian threats to U.S. strategic interests, and there are responses to the use of sanctions and other tools of disruption. The fallout from this rift will take years to play out.

A team of IMF economists have written a Discussion Note on Geoeconomic Fragmentation and the Future of Multilateralism. They attribute the reversal of economic integration to national considerations, such as the desire of governments to increase their domestic production capabilities in particular areas. But the authors of the Note point out that while fragmentation may achieve some goals, it also imposes costs. These include: “higher import prices, segmented markets, diminished access to technology and to both skilled and unskilled labor, and ultimately reduced productivity which may result in lower living standards.” Moreover, fragmentation will slow down joint efforts to address global issues such as climate change.

The Discussion Note summarizes the results of several studies of the loss from geoeconomic fragmentation. In all the studies they cite, the costs are greater the larger the degree of fragmentation. Among the reasons for the losses in output are reduced knowledge diffusion due to technological decoupling. Not surprisingly, low income and emerging market countries are most at risk from a separation from the latest technological developments.

Pinelopi K. Goldberg of Yale and Tristan Reed of the World Bank Group (Goldberg is former chief economist of the World Bank) examine the prospects for global trade in their recent NBER Working Paper “Is the Global Economy Deglobalizing? And if so, why? And what is next?” They find that “slowbalization” is a better description of the recent trend in international trade than “deglobalization.” Foreign direct investment and migration have exhibited relatively less slowdowns. But the authors also document changes in U.S. policies and public attitudes that represent a marked shift away from the liberalization of trade. They attribute these reversals to various factors, including the impact of imports on U.S. labor, concerns over the resilience of global supply chains, and national security considerations.

Goldberg and Reed conclude their analysis with some projections of the consequences of deglobalization. They point out that the previous regime of the last three decades led to growth and technological progress They warn that global innovation will be particularly slowed by a decoupling of the U.S. and China  Reconfiguring production supply chains will slow growth as well. These reversals and changes raise the possibility that the recent decline in global inequality will halt, with low-income countries most at risk.

Trade, of course, is not the only component of international commerce that has undergone changes in how it is organized. Chapter 4 of the IMF’s most recent World Economic Outlook analyses the geoeconomic fragmentation of FDI. The authors point to an increase in the “reshoring” and “friend-shoring” of production facilities domestically or to countries with similar political alignments. They estimate a model of the impact of geopolitical alignment on FDI flows, and find that geopolitical factors account for part of the shift in bilateral FDI to countries with governments with similar views to the home country. This could presage a shift to more FDI among advanced economies, rather than emerging markets and developing economies that may differ on political issues.

The Fund’s economists also analyzed the output costs of FDI fragmentation. They utilized different scenarios of geopolitical alignment, such as a world divided into a U.S.-centered block and a China-centered block, with India and Indonesia and Latin America and the Caribbean as nonaligned. In this scenario, the impact of smaller capital stocks and less productivity cumulate with long-term output losses of 2%. Other scenarios allow for the diversion of investment flows to some areas that could offset a decline in global economic activity. However, the chapter’s authors also warn that nonaligned nations may face pressures to choose one side over the other. They conclude from their analysis: “…a fragmented global economy is likely to be a poorer one. While there may be relative—and possibly absolute—winners from diversion, such gains are subject to substantial uncertainty.”

Other forms of capital flows are also subject to fragmentation, and the IMF’s economists examine these trends is a chapter of the latest Global Stability Report. In their analysis, geopolitical tensions can lead to instability through two channels. The first is a financial channel that could respond to increased restrictions on capital flows, greater uncertainty or conflict. The second channel is a real channel, due to disruptions in trade and technology transfers or volatile commodity markets. These two channels can reinforce each other. Restrictions in trade, for example, could discourage cross-border investments.

Geopolitical affinities affect cross-border capital allocation, and the evidence reported in the chapter indicates that recent events have reinforced this impact. The empirical analysis based on a gravity model finds that a rise in geopolitical tensions can trigger sizable portfolio and bank outflows, particularly in developing and emerging market economies. Geopolitical fragmentation can also lead to a loss in international risk diversification, thus leaving countries more vulnerable to adverse shocks and a sizable welfare loss.

All these analyses from multilateral institutions warn of the negative economic consequences arising from the decoupling of trade and financial ties. But the most threatening effects may come from the deepening division of the world into different blocs. As the dividing lines become solidified, the chances of discord extending beyond economic interactions increase. All this friction arising when climate warming already poses a clear threat to our existence only intensifies the dangers we will face.

China’s Outward FDI

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Chinese firms that want to list their stock in U.S. equity markets face a series of hurdles. The Securities and Exchange Commission is implementing a new rule that requires the firms to provide information regarding their ties to the Chinese government, while the Biden administration is banning Americans from investing in 59 Chinese firms. Moreover, Chinese authorities have their own concerns about the foreign listing of Chinese firms. Chinese multinationals also face impediments to their foreign expansion through direct investment, but they have been successful in expanding their foreign operations, and this is slowly transforming China’s external balance sheet.

China, of course, is a creditor country, with a net international investment position (NIIP) in 2020 of $2,150 billion. Historically its balance sheet has been characterized as “long debt, short equity,” i.e., China held the debt issued by borrowers in the advanced economies (such as U.S. Treasury bonds) and issued equity liabilities, usually in the form of foreign direct investment (FDI). This strategy allowed China to benefit from the expertise of multinational firms and foreign technology, while avoiding the need to depend on its own undeveloped financial markets to arrange financing. But Chinese firms are at the stage where they can compete in foreign markets, and have been acquiring foreign affiliates.

In 2010, Chinese FDI assets were worth $317 billion, while Chinese FDI liabilities were valued at $1,570 billion, for a net FDI position of -$1,252 billion, or -20.6% of Chinese GDP. Chinese  outward FDI flows have grown since then, and the stock of assets reached $2,237 billion in 2019. (These changes also reflect the effects of currency value fluctuations.)  While the stock of liabilities was still larger at $2,796 billion, the gap between them had shrunk to $560 billion, only about 4% of GDP.

Dongkun Li and Yang Zhang provide an occount of the evolution of Chinese outward FDI in their article, “Compressed Development of Outward Foreign Direct Investment: New Challenges to the Chinese Government,” which appeared in the Journal of African and Asian Studes in 2020.  In the 1990s Chinese FDI was usually undertaken by state owned enterprises and focused on the acquisition of natural resources, particularly in developing economies. The government endorsed FDI as part of its growth strategy, however, and FDI outflows grew rapidly after 2001 as private enterprises increased their share of China’s outward expansion. There was a slowdown in 2017 when the Chinese government, concerned about capital outflows, imposed restrictions on outward FDI. Foreign expansion has continued, albeit at a slower pace, and has been given a new focus under the Belt and Road Initiative.

The increase in Chinese firms’ foreign activities has also affected China’s net investment income. Despite its NIIP creditor position, China has recorded deficits on net investment income, as payments on its FDI liabilities traditionally have exceeded the returns China received on its largely debt-dominated assets. But China’s net investment income deficit, which reached $85.3 billion in 2011, had fallen to $43.4 billion in 2019.

There was a reversal in these trends last year. China was the largest recipient of FDI in 2020, bypassing the U.S. Chinese FDI liabilities jumped to $3,179 billion, and the net FDI position fell to -$765 billion, about -5.2% of GDP. The deficit on net investment income rose to $107 billion. FDI inflows continued to be strong in the first quarter of this year. However, outward FDI increased from its depressed 2020 amount.

The future development of FDI both inside and outside China depends a great deal on government policies, as well as the uncertain course of the pandemic. In the U.S., the Committee on Foreign Investment examines proposed acquisitions of U.S. firms,  and blocks access to U.S. technology that could affect U.S. security. European governments are also scrutinizing Chinese investment, and that screening combined with the effect of the pandemic resulted in a large drop in Chinese FDI flows to Europe last year. The Chinese government also seeks to controls foreign ties as part of its overall move to assert more government control of the economy. But Chinese firms are eager to expand, and over time their search for new markets should lead to further shifts in China’s net FDI position and foreign investment earnings.

International Factor Income in 2020

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The sharp contraction in economic activity in the first half of 2020 due to the COVID pandemic was followed by a slow and uneven recovery in the second half of the year. The decline slowed global trade and capital flows, although not as much as initially expected. The economc slowdown also lowered investment income and remittances, the two main forms of international factor income payments. (There is also rent received on property.) Will these also recover as economic growth resumes?

Net investment income appears in the current account of the balance of payments as part of net primary income. For most countries FDI income is the largest component of investment income, followed by portfolio (equity and debt) income and other (mainly bank) income. The largest net recipients of FDI income are the U.S., Japan, Germany and France, all home countries for multinationals. Emerging markets economies that attract FDI flows, such as India and China, are major net payers of FDI income. Ireland, which attracts multinationals with its low corporate tax rates and its proximity to continental Europe, also records large FDI income deficits.

The latest issue of the OECD’s FDI in Figures reports FDI income for 2020 for the OECD area. Total FDI receipts were $1.80 trillion and payments were $1.04 trillion, which result in net FDI income payments of $418 billion. Almost three-quarters of the OECD income earnings were paid out to the parent countries, with the remainder reinvested in the host countries.

As expected, the 2020 FDI income flows represented declines from those of 2019, which the OECD attributed to the pandemic. The percent changes—a drop in receipts of 16% and of 15% in payments—were similar to those recorded during the global financial crisis. Moreover, the 2019 earnings were below those of 2018 due to slowing economic growth.

A recovery in FDI income will depend in part on the future course of FDI flows. Global FDI flows decreased by 38% in 2020 to $846 billion, their lower level since 2005. When scaled by GDP, they represented 1% of world GDP, the lowest relative level since 1999. In the OECD area, much of this decline was driven by disinvestments from Switzerland and the Netherlands, which serve as financial centers for companies with headquarters in other countries. The OECD reports a rise in cross-border mergers and acquisitions in the second half of 2020 and the first quarter to 2021.

The outlook for FDI-associated income also depends on the outcome of the talks sponsored by the OECD to harmonize the rules governing how tax rights are determined amongst jurisdictions, and also to set a minimum global tax rate. Multinational firms have been able to take advantage of the differences in corporate tax rates among nations by basing their operations in tax havens such as Luxembourg and Bermuda. If the negotiating parties come to an agreement, multinational firms will have to reassess the locations of their operations. They are most likely to cut back their use of the tax havens, but how they will restructure their activities and the impact on global supply chains is not clear.

There is also uncertainty over the impact of government policies on multinational investments. The U.S. and Chinese governments have indicated that they want to build up their respective domestic capacities in a number of areas, and will use trade and financial restrictions to promote domestic suppliers while limiting foreign access. Controls on inward FDI, for example, are used to deny foreign firms and governments access to domestic technology. Trade barriers also inhibit companies from expanding their operations, and the Biden administration has indicated that it will take an aggressive response to what it perceives as unfair Chinese policies.

Remittances fared better in 2020, according to the World Bank, falling to $540 billion, only 1.6% below the previous year’s level. With the exception of China, remittances exceeded the total of FDI flows and financial assistance to developing countries. The true value may be higher since not all remittances are recorded. The largest recipients in absolute terms were India, China, Mexico, the Philippines and Egypt, all countries with large labor forces. The U.S. was the largest source of the remittances, followed by the United Arab Emirates, Saudi Arabia and the Russian Federation.

Why were remittances so strong? Gabriella Cova of the Atlantic Council writes that many migrants believed that conditions in their home countries were worse than in their host countries, and continued to send money home. Consequently, the reminttances were counter-cyclical for the recipient countries, partially offsetting the domestic economic contraction. The migrants who retained jobs in “essential” sectors were able to send money to their home countries. Moreover, the appreciation of the dollar increased the domestic values of their payments.

The future for migrants and their remittances, like FDI, is also uncertain. Developed countries with aging workforces will increasingly need migrants to take the place of native-born workers. On the other hand, the closure of borders during the pandemic may reinforce the trend to technological solutions. Japan, for example, has been developing robotic care for the health sector. Border control is a contentious area of public policy, although the pandemic also demonstrated the need for workers to undertake basic tasks in food production, distribution and delivery.

International factor payments have become increasingly important components of the balance of payments. Depending upon their value, they can either offset or amplify a trade account deficit (see Forbes, Hjortsoe and Nenova 2016). They also distinguish GDP from GNP, and can affect income inequality in both the home and host countries. The COVID pandemic disrupted them, particularly FDI income, and their future depends on how capital and labor flows are restructured after the pandemic.

International Factor Payments and the Pandemic

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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:

http://econbrowser.com/archives/2020/07/guest-contribution-international-factor-payments-and-the-pandemic

The True Owners of Foreign Capital

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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 Change in the U.S. Direct Investment Position

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The U.S. has long held an external balance sheet that is comprised of foreign equity assets, mainly in the form of direct investment (DI), and liabilities held abroad primarily in the form of debt, including U.S. Treasury securities. This composition is known as “long equity, short debt.” Pierre-Olivier Gourinchas of UC-Berkeley and Hélène Rey of the London Business School claim that this allocation has allowed the U.S. to serve as the “world’s venture capitalist,” issuing short-term debt in order to invest in high-yield assets. But the U.S. direct investment position has changed from a surplus to a deficit, with uncertain consequences for the international monetary system.

There is more than one reason for the change. To see this, it is important to understand that the U.S. Bureau of Economic Analysis, which reports these data, uses several methods to value direct investment. One of these utilizes stock market prices to calculate the market values of the assets and liabilities. The second method is the use of the historical costs of the investments when they were made. The third is the current, or replacement, costs of the direct investment assets and liabilities.

Direct investment includes equity and debt instruments. The latter is based on intra-company borrowing. Historically, the equity component has registered a net positive position that outweighed the negative debt position. But the net direct investment equity position, which had been falling for several years, plunged in late 2017. The falloff continued in 2018 and led to a negative balance, which combined with the negative net direct investment debt position, turned the overall net direct investment balance negative.

What was the cause of the dropoff in direct investment equity? An examination of the assets and liabilities based on their market value shows both falling, with the decline in asset values outweighing a fall in the value of liabilities. These drops are based in large part on last year’s domestic and foreign stock market declines.

But an examination of the assets and liabilities valued at historic costs reveals that there was also a decline in direct investment assets. This fallback is due to the repatriation of earnings that U.S. based multinationals had accumulated and kept abroad in order to avoid paying corporate taxes on them. When changes in U.S. tax laws went into effect last year, many firms brought their earnings back, which led to negative U.S. direct investment outflows. Our direct investment assets fell, therefore, both because of the fall in their market value but also due to the reduction in U.S. foreign holdings. Inward investment, on the other hand, continued to grow.

What does this portend for the future? U.S. direct investment outflows became positive again in the second half of 2018. But they are unlikely to return to the same amounts as they had registered before the change in the tax laws due to concerns of the firms over U.S. trade policy. This year’s rising U.S. stock market will increase the value of our liabilities, most likely at a faster rate than the corresponding change in the market value of our assets. Consequently, the net debtor DI position will continue at least for the short-term.

This imbalance in our direct investment assets and liabilities contributes to the deterioration in the U.S. net international investment position. In addition, once the repatriation of foreign earnings is complete, the positive income we receive on our net foreign assets that partially offsets the deficit in the trade balance may fall. Moreover, the ability to serve as the world’s venture capitalist will weaken, which will affect our response to the next major financial crisis. The U.S. may not undertake the stabilizing role it has played in the past, and there is no other nation that can or will take on that role. At a time when the U.S. is withdrawing from political commitments that it has maintained since the end of World War II, this change is yet one more sign of a self-imposed diminution in our ability to deal with global issues.

(Note: a major thanks to the economists at the Bureau of Economic Analysis for guiding me through the data on direct investment.)

 

 

Partners, Not Debtors: The External Liabilities of Emerging Market Economies

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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