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Is There a Future for FDI?

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

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

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

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

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

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

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

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

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

The 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 Changing Nature of FDI

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

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

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

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

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

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

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

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

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

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

Does France Have an “Exorbitant Privilege”?

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The U.S. has long been accused of using the international role of the dollar to exercise an “exorbitant privilege.” The term, first used by French finance minister Valéry Giscard d’Estaing, refers to the ability of the U.S. to finance its current account deficits and acquire foreign assets by issuing dollars as a reserve currency. While flexible exchange rates have lowered the need for reserve currencies, the use of the dollar in international trade and finance ensures that there is a continuing need for dollar-denominated assets. The status of the dollar contributes to the surplus in U.S. international investment income despite its negative net international investment position (NIIP). But France also has a surplus in international investment income and a negative NIIP. Does it possess its own privilege?

The U.S. surplus reflects the composition of its external balance sheet as well as the return on its assets and liabilities. The U.S. has a positive balance on equity, and in particular, FDI, which is offset by the negative balance on portfolio securities, such as bonds. U.S. Treasury bonds are the universal “safe asset,” held by private foreign investors as well as central banks. The return on the equity assets exceeds that paid on the debt liabilities, thus yielding a positive investment income balance. This is the return that the U.S. receives for playing the role of the “world’s venture capitalist,” according to Pierre-Olivier Gourinchas of UC-Berkeley and Hélène Rey of the London Business School. In addition, the U.S. receives a higher return on its FDI assets than it pays out on its FDI liabilities.

France also has a negative NIIP but a positive net international investment income balance. In 2018, for example, it received $35.6 billion in investment income. Moreover, the Banque de France pointed out in the 2015 Annual Report on the French Balance of Payments and International Investment Position that while the ratio of outward direct investment stocks to liabilities was 2 to 1, the ratio of FDI receipts to payments was 3 to 1. The French surplus, like that of the U.S., therefore can be attributed to both a “composition” effect reflecting the difference in the types of assets and liabilities it possesses, but also a “returns” effect due to the relatively higher return on its direct investment assets vis-à-vis its liabilities.

Vincent Vicard of CEPII (Centre d’Etudes Prospectives et d’Informations Internationales) has examined this return in a CEPII working paper, “The Exorbitant Privilege of High Tax Countries.” He finds that French firms earn higher returns on their foreign operations in low tax countries and tax havens, evidence of using the reporting of profits to increase returns. Profit shifting by the French multinationals account for two percentage points of the difference in returns on French assets and liabilities. Four European countries account for much of this activity: Luxembourg, Netherlands, Switzerland and the United Kingdom.

These results are consistent with those reported for other countries, particularly the U.S. Kim Clausing of Reed College, for example, examined the impact of differentials in tax rates on the profits of U.S affiliates in “Multinational Firm Tax Avoidance and Tax Policy” in the National Tax Journal in 2009.  More recently, Thomas Tørsløv and Ludvig Wier, both of the University of Copehhagen, and Gabriel Zucman of UC-Berkeley investigated the profit-shifting of multinationals in a range of countries in a NBER Working Paper, “The Missing Profits of Nations.” They estimate that close to 40% of multinational profits are shifted to tax havens globally each year. The non-haven European Union countries appear to be the main losers from this maneuvering.

But it would be too simple to dismiss the foreign earnings of French or U.S. firms as a purely accounting artifact. Multinationals have used information and communications technology to form global supply chains that allow them to source operations in low-cost countries and assemble the components elsewhere before shipment to the final market. France has its share of multinationals, including firms such as BNP Paribus, Carrefour and Peugeot. Moreover, foreign economic expansion by French firms and investors predates modern tax codes. Thomas Piketty of the School for Advanced Studies in the Social Sciences and the Paris School of Economics  pointed out in Capital in the Twenty-First Century that the income earned from foreign holdings were sufficient to finance trade deficits and capital outflows in Great Britain and France during the late nineteenth and early twentieth centuries.

The U.S. and other governments have lowered corporate tax rates in part to lure multinationals back to their home countries, and the members of the Organization for Economic Cooperation and Development intend to limit profit shifting by multinationals. Whether or not this strategy will be successful is not clear. Chris Jones and Yama Temouri of the Aston Business School have pointed out in “The Determinants of Tax Haven FDI” in the Journal of World Business that tax havens have advantages for multinationals besides lower tax rates, including few regulations and restricted openness. But President Trump has also made clear that he wants U.S. firms to operate domestically, and is willing to limit access to U.S. markets by foreign firms. France’s “privilege,” exorbitant or not, will be affected by these restrictions.

Global Firms, National Policies

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Studies of international transactions often assume that national economies function as separate “islands” or “planets.” Each has its own markets and currency, and international trade and finance occurs when the residents of one economy exchange goods and services or financial assets with those of another. The balance of payments keeps track of the transactions. But in reality firms treat the differences across nations as opportunities to increase their profits, and their decisions on basing the location of their activities–or how they report the basing of the activities–reflect this.

Multinational companies are not new entities; they can be traced back to the European trading companies that colonized the Americas, Asia and Africa. In the twentieth century, firms expanded across borders to get around trade barriers, to obtain access to raw materials, and to produce their goods more cheaply using foreign labor. Advances in the technology of shipping (container ships) and communications (Internet) spurred the development of global supply chains. Firms divided the production of goods among countries in order to manufacture them at the lowest cost before assembly into a final product. Shipments of these intermediate goods have become a major component of international trade, and intermediate inputs represent a significant portion of the value of exports .

This stratification of production has several implications, as Shimelse Ali and Uri Dadush of the Carnegie Endowment for International Peace have pointed out. Bilateral trade balances, for example, are distorted. U.S. imports from China contain a significant amount of intermediate inputs from other countries. Measuring only the value-added by Chinese firms to their exports lowers its trade surplus with the U.S. by a significant amount.

Moreover, tariffs on intermediate goods have impacts all along the global supply chain. The trade restrictions imposed by the Trump administration are rippling through the U.S. economy, raising the costs of production for those firms that depend on foreign supplies of goods that are subject to the tariffs. Daniel Ikenson of the Cato Institute has found that the U.S. transportation, construction and manufacturing sectors are those that are among those most affected by the tariffs. If the tariffs are not removed, firms will reconsider investing in new production facilities.

Global supply links also affect the current accounts of the nations where the multinationals are based. When these firms establish foreign subsidiaries in order to take advantage of cheaper costs abroad, then their home countries record less trade but more primary income resulting from the operations of the subsidiaries. The countries that receive the largest amounts of primary income include the U.S., Japan, France and Germany, all home countries of multinationals with extensive foreign operations. Net primary income does not receive as much publicity as fluctuations in the balance of trade, but the primary income balance has increased in magnitude, and in some cases dominates the current account. Japan’s net income surplus has in some years more than offset its trade deficits, while the United Kingdom’s current account deficit is due primarily to its net income deficit.

These foreign operations also give the multinational firms the opportunity to take advantage of differences in national tax systems. Stefan Avdjiev and Hyun Song Shin of the of the Bank for International Settlements and Mary Everett and Philip R. Lane of the Central Bank of Ireland have shown some of the consequences of these maneuvers. Firms can manipulate the value of their foreign profits in order to lower their tax liabilities. Until recently, the U.S. taxed multinational firms headquartered here on their global profits, with credits given for foreign taxes. The foreign profits were not taxed until they were repatriated. Firms could book profits in low-tax jurisdictions—known as “tax havens”—and keep those profits outside the U.S.

Those foreign profits could be increased by lowering the recorded cost of inputs from the U.S. and raising the value of goods sent back, thus increasing the profits recorded by the foreign subsidiary. Such “transfer prices” should be based on their market value, but in many cases there are none, which give the firms the opportunity to understate their domestic profits and overstate their foreign profits, which are subject to the lower tax. Similarly, intellectual property assets could be shifted to low-tax jurisdictions.

Thomas R. Tørsløv and Ludvig Wier of the University of Copenhagen and Gabriel Zucman of UC-Berkeley have investigated this movement of profits to tax havens. They estimate that about 40% of multinational profits are shifted to tax havens, such as Ireland, Luxembourg and Singapore.  As a result, the home countries of the multinational firms—particularly the non-haven European Union nations—lose tax revenues. The shareholders of the multinationals—particularly those based in the U.S.—are among the main winners.

Governments are well aware of the activities of the multinationals, and the loss of tax revenues. Kim Clausing of Reed College has estimated that profit shifting by U.S. multinational corporations reduces U.S. government tax revenues by more than $100 billion each year. The Organization of Economic Cooperation and Development has taken the lead in formulating policies to tackle what it calls “Base Erosion and Profit Shifting (BEPS). To date over 100 countries have agreed to participate. The recent tax code changes in the U.S. have greatly reduced the incentive for U.S. firms to record and hold profits overseas. Multinationals such as Google and Starbucks are receiving close scrutiny of their international profits, and Apple has been ordered to pay back taxes to Ireland.

The OECD’s initiative, as well as the work of advocacy groups such as the Tax Justice Network, has increased the visibility of the activities of the multinationals designed to lower taxes. But the existence of different factor costs and divergent tax codes will always provide incentives for tax lawyers and accountants to devise new ways of lowering the taxes of the multinationals. In a Westphalian world, domestic governments are reluctant to give up their sovereignty. As a result, multinationals that are much more adept in dancing around national borders will  take advantage of any opportunities they see.