Tag Archives: multinationals

The Changing Nature of FDI

Leave a reply

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”?

Leave a reply

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

Leave a reply

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.