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Has Globalization Been Reversed?

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The disruption of the global economy caused by the COVID pandemic in 2020 had begun to be overcome when the Russian invasion of Ukraine in 2022 led to new fissures. Sanctions were placed by the United States and European nations on trade and capital transactions with Russia. Before the pandemic, tariffs and other trade measures had been imposed by the  United States and China on each other, and these restrictions were continued under the Biden administration. How far has the reversal of the measures designed to promote international trade and finance gone, and has globalization been set back?

 Jesús Fernández-Villaverde, Tomohide Mineyama and Dongho Song in a new NBER working paper, “Are We Fragmented Yet? Measuring Geopolitical Fragmentation and Its Causal Effect,” devise an empirical measure of geopolitical fragmentation using a dynamic factor model.  They selected 14 indicators, including economic measures such as FDI/GDP, the number of trade restrictions, and migration flows as well as political indicators, such as the number of international conflicts. The data begin in 1975 and include 61 countries, 34 advanced and 27 emerging markets. Their measure shows a high degree of stability between 1975 through the early 1990s, when political events led to a decline in fragmentation, as the Soviet Union dissolved, the World Trade Organization was formed, and the euro was created. This trend began to reverse during the time of the 2008-09 financial crisis, and the estimated fragmentation index has steadily risen.

The authors then use their index to examine its impact on economic outcomes, including the impact on GDP per capita, industrial production and fixed investment. They find that a rise in fragmentation affects the global economy adversely, with emerging economies suffering more of an impact. They also find asymmetries in the timing of the effect of an increase in fragmentation vs. a decline, with the negative effects of a rise in fragmentation taking place more quickly than the positive impact of a decline in fragmentation.

A different view of the extent of fragmentation has been presented by Steven A. Altman and Caroline R. Bastian in “The State of Globalization in 2023”, which appeared in the July 2023 issue of the Harvard Business Review. Both authors are affiliated with the DHL Initiative on Globalization at NYU’s  Stern Center. They used the DHL Global Connectedness Index, which measures the growth of trade, capital, people and information relative to the growth of the domestic economy. The first three measure declined in response to the COVID pandemic, but trade and capital have recovered. International travel has not returned to pre-pandemic levels, although migration has. Flows of information, on the other hand, increased during the pandemic and afterwards as people turned to the Internet after shutdowns limited public activity.

The authors did find evidence of a drop in U.S.-China economic flows, although the two economies still have substantial linkages. Moreover, they report that allies of each country have not reduced trade with the other country. Regionalization has not succeeded globalization, and the authors claim that firms that retreat from globalization may lose a firm’s competitive position.

An analysis of one country’s response to fragmentation is presented in “Germany’s FDI in Times of Geopolitical Fragmentation”, a 2024 IMF working paper by Kevin Fletcher, Veronika Grimm, Thilo Kroeger, Aiko Mineshima, Christian Ochsner, Andrea F. Presbitero, Paul Schmidt-Engelbertz and Jing Zhou’s. Germany is sensitive to external shocks, such as the rise in energy prices that followed the Russian invasion and the authors sought to determine how geopolitical risk and energy prices could affect FDI flows. Among their findings they report that the post-pandemic recovery in both inward and outward FDI have been slower in Germany than in the U.S. or the rest of Europe. They also find that Germany’s outward FDI linkages with geopolitically distant countries have been weakening, in particular FDI to China-Russia-bloc nations.

Measuring and analyzing fragmentation and its consequences will remain an active area of research. Compounding the challenges of obtaining relevant data is the uncertainty of the future. The pace and extent of globalization will be driven in part by political decisions. By the end of this year there will be executive changes in many of the  largest economies. Consequently, the political landscape will change and new restrictive policies could impede the integration of markets. National leaders will assess the challenges they face and the responses they choose may diminish global, welfare.

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.

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.

“The Sources of International Investment Income in Emerging Market Economies”

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The Review of International Economics has published my paper on “The Sources of International Investment Income in Emerging Market Economies” in its latest issue. You can find the paper here, and this is the abstract:

We investigate international investment income flows in 26 emerging market countries during the period of 1998–2015. Net investment income registered a deficit for this group of countries of between 2% and 3% of GDP during this period. This deficit has been dominated by payments on foreign direct investment liabilities, which is consistent with the change in the composition of the external liabilities of these countries. Our results indicate that both capital account and trade openness are associated with the deficits on direct investment income. In addition, there was a small deficit in portfolio investment income, which is affected by the development of domestic financial markets and investor protection. Other investments’ income and the income from foreign exchange reserves have a negligible role in total investment income.

The Need for a Global Corporate Tax Regime

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When the Organization for Economic Cooperation and Development began its call for a reform of the rules of global taxes in order to clamp down on the avoidance of taxes by multinational corporations, its efforts looked quixotic. But the OECD persisted, and U.S. Treasury Secretary Janet Yellen is now participating in negotiations with the other OECD members to reform the (non-)system. While there is much left to negotiate, the broad framework of an agreement to establish a new regime, which governs where taxes are assessed and the determination of a global minimum tax, now exists.

A new volume edited by IMF economists Ruud A. de Mooij, Alexander D. Klemm and Victoria J. Perry, Corporate Income Taxes under Pressure : Why Reform Is Needed and How It Could Be Designed, presents the case for implementing a global approach. The first part of the volume describes the reasons for taxing corporate profits, explains the emergence of the rules governing how multinationals could be treated, and shows the complications that the growth in services and digital trade placed on an already fragile system. The second section examines the workings of the current system, including the difference between source-based and residence-based taxes, the use of bilateral tax treaties to allocate taxing rights, and the ability of corporations to use the differences amongst tax regimes to lower their liabilities by shifting the source of their profits to low-tax jurisdictions. The third section analyzes the relative merits of various reform proposals.

The magnitude of lost tax revenues can only be estimated, since multinationals are not required to report all the data on their operations. But economists have used the available data in inventive ways to estimate the losses.  Kimberly Clausing of Reed College explains the data limitations and the attempts to provide reasonable estimates with the data that are available in a recent paper,  “How Big is Profit Shifting?”. Most of the profit shifting undertaken by U.S.-based multinationals occurs with a few tax havens: Bermuda, Cayman Islands, Ireland, Luxembourg, Netherlands. Singapore, and Switzerland. Clausing calculates that U.S. tax revenue losses from such activities may gave reached $100 billion in 2017, about a third of federal corporate tax revenues.

The OECD has made available a great deal of documentation on the challenges of profit shifting and the proposals to arrest these activities. Many of these analyses are summarized in Addressing the Tax Challenges from the Digitalisation of the Economy: Highlights. The first part of the document explains the proposals under negotiation, known as Pillar One and Pillar Two. Pillar One expands the right to tax a firm beyond its physical presence in a jurisdiction to include “…a significant and sustained participation of a business in the economy of the jurisdiction, either physically or remotely.” Pillar Two ensures a minimum level of tax on the profits of multinationals.

The OECD estimates that if both proposals were implemented, there would be revenue gains for low, middle and high income jurisdictions. The impact of “investment hubs” is more ambiguous, but they would lose some of their tax base. But could these changes adversely affect business activity? The OECD acknowledges that investment costs would rise, but estimates that the impact on investment would be minor.

Tibor Hanappi amd Ana Cinta González Cabral of the OECD Centre for Tax Policy and Administration present a detailed examination of the effect on investment costs in their paper, “The Impact of the Pillar One and Pillar Two Proposals on MNE’s Investment Costs: An Analysis Using Forward-Looking Effective Tax Rates.” They estimate that the rise in the effective average tax rates (EATR) of multinationals in their sample of 70 jurisdictions would be 0.4 of a percentage point, which is small compared to the existing weighted average 24% EATR. Moreover, the reduction in tax differentials would make other factors, such as education and infrastructure in host countries, more important in determining the location and scale of investments.

An agreement on multinational taxes would benefit the Biden administration, which needs revenue to pay for its ambitious infrastructure plans. The administration could use the implementation of a global tax to counter claims that an increase in the U.S. corporate income tax rate, which fell from 35% to 21% in the Trump administration, would make U.S. firms uncompetitive. A coordinated system of taxes would also be a response to the challenge to the ability of governments to tax businesses that profit shifting has posed. Only a global system would stop the “race to the bottom” of national corporate taxes that has resulted in the current tax regime.

Financial Globalization and Inequality

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The global financial crisis slowed the pace of financial globalization, while the impact of the pandemic on its future course is unclear. But enough time has elapsed to assess the record of integrated financial markets that greatly expanded in the 1990s and early 2000s. The evidence on one issue—financial openness and inequality—is clear: financial globalization has increased inequality.

Enrico D’Elia of the Italian Ministry of Economy and Finance and the Italian Institute of Statistics (ISTAT) and Roberta De Santiss, also of ISTAT, analyzed this issue in their 2019 working paper, “Growth Divergence and Income Inequality in OECD Countries: The Role of Trade and Financial Openness.” They used an error-correction model to differentiate between short- and long-run effects on the Gini index, and divided the OECD countries into low-, middle- and high income over the period of 1995-2016. Increases in financial integration, as measured by foreign assts and liabilities scaled by GDP, increased income disparities in both the short- and long-run in the total sample. In the long-run there is a negative effect on the Gini index within the low-income countries, but there is a much larger positive impact within the high-income group. They attribute this finding to the advantage that the financial sector derives from financial innovation in those countries. In their results relating to growth, they reported that financial openness had a positive impact on the economic growth of the middle-income group alone, and it only occurred in the short-run.

Xiang Li of the Halle Institute for Economic Research and Dan Su of the University of Minnesota investigated the impact of capital account liberalization in their 2020 article, “Does Capital Account Liberalization Affect Income Inequality?” in the Oxford Bulletin of Economics and Statistics. They used several measures of capital account openness, and both Gini coefficients and the income shares of different groups as their measures of inequality in samples of OECD and non-OECD countries. In their panel data analysis, they found that capital account liberalization had positive impacts on the Gini coefficients in the non-OECD countries, but not the OECD sample. They also found that capital account liberalization increased the income share of the top 10% of households. They reported similar results from a difference-in-differences analysis.

Philipp Heimberger of the Vienna Institute for International Economic Studies offered a summary of the empirical analyses of economic globalization and inequality in his paper, Does Economic Globalisation Affect Income Inequality? A Meta-analysis, which was published in The World Economy in 2020. He undertook a meta-analysis of 123 peer-reviewed papers and a meta-regression empirical analysis. In his results he found that financial globalization has had a sizeable and significant inequality-increasing impact, which is not true of trade globalization. Moreover, this result holds for advanced countries as well as developing nations.

The evidence, therefore, seems clear: increased capital flows do lead to more income inequality. But what are the channels of transmission? Barry Eichengreen of UC-Berkeley, Balazs Csonto and Asmaa A. El-Ganainy of the IMF, and Zsoka Koczan of the European Bank for Reconstruction and Development investigate this issue in their IMF working paper, “Financial Globalization and Inequality: Capital Flows as a Two-Edged Sword.” They point out that the various types of capital flows will have different effects and review the separate impacts to explain why inequality increased in both advanced and developing economies.

In the case of inward FDI in developing economies, the inflow of foreign capital could increase the return to labor. But, the authors point out, if capital substitutes for labor or works with skilled labor, then wage inequality will increase amongst laborers. This effect will be magnified when foreign capital flows to sectors that are dependent on external capital and are also complementary with skilled labor. Similarly, outward FDI reduces the demand for less skilled labor in the home countries of the multinationals responsible for the FDI. The outflows can also lower the bargaining power of labor in those countries.

The authors also examine portfolio capital, which can have many of the same distributional consequences as FDI in the host countries. Moreover, inflows of portfolio capital can lead to increased macroeconomic and financial volatility, and culminate in crises. Aggregate volatility heightens inequality because the poor suffer more the effects of economic downturns. In addition, portfolio flows can lead to increased demand for assets and higher prices. A rise in housing prices helps their owners, and the distributional impact depends on the pattern of ownership. In the case of higher stock prices, the benefits flow to stockholders who almost always are located in high-income households.

FDI, portfolio capital and bank flows also affect tax payments. Multinationals can use financial centers with low tax rates to minimize their tax liabilities across nations. Portfolio and bank flows can be used by the rich to shelter their asset holdings to avoid taxes. The loss of tax revenues decreases the ability of governments to deliver services that may benefit poorer households.

What can be done in the face of these impacts on income inequality? The authors of the IMF paper point out that adverse consequences are lessened when there are higher levels of educational achievement in the population. More educated workers benefit from the increased skill premium paid by multinationals. Capital flow measures can be used to control short-run inflows that can lead to “sudden stops” that overwhelm domestic financial markets.

A multilateral initiative seeks to reform the tax treatment of multinationals to avoid base erosion and profit shifting (BEPS) that result in lower tax revenues for governments. The OECD has organized negotiations amongst governments to coordinate the tax treatments of multinational firms. The OECD proposals have two sections: the first deals with the allocation of the right to levy taxes on corporations by nations and the second would establish a minimum global tax. These issues are particularly relevant for digital companies that have minimum physical presence in many countries where they do business. U.S. Treasury Secretary Janet Yellen has announced that the U.S. would reverse its position under the Trump administration and engage in these talks.

Finance, if designed properly, need not be exclusionary. Indeed, in some countries financial inclusion has helped low-income households to increase their living standards. International financial flows are not the only cause of increased inequality, but they have played a role. International finance in all its forms can have adverse consequences and governments need to acknowledge these and plan to offset them if/when financial globalization resumes.

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.

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