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If there’s one subject on which policymakers around the world seem to agree, it’s that foreign direct investment is a Good Thing.
The annual tables of inward foreign direct investment (FDI) are treated by governments of rich and poor economies alike much as football fans treat rankings in the English Premier League, crowed over by countries in the leading pack and quietly forgotten by those in the relegation zone.
There is no doubt that FDI can do a lot of good: it can add to an economy’s productive capacity and import not just capital but technology, production skills and better management. China, which not only welcomed FDI but witnessed intense competition between different provinces to attract it, stands as a shining example.
Like good cholesterol versus bad cholesterol, FDI is also more stable than portfolio investment and bank loans, which have a nasty habit of reversing quickly in a crisis. A government whose economy is running a current account deficit but attracting lots of FDI can argue that the deficit reflects more investment opportunities than the country can finance itself, rather than a low savings rate and excessive consumption.
Emerging markets are taking a rising share of both inward and outward FDI, which has recovered after plunging in the years after the global financial crisis. But this is not an unalloyed benefit. Incentives given to attract investment can be expensive and hard to undo. And if investments are more to do with capturing market share and financial engineering than they are to do with increasing the capital stock, they may diminish the competitiveness of domestic firms or leave EMs subject to sudden reversals of capital.
The efficacy and benefit-cost advantage of FDI incentives such as tax breaks has long been questioned. If companies would have invested anyway, subsidising them to do so means giving up valuable tax revenue for nothing. Moreover, privileging a particular set of businesses or targeting a particular sector can introduce distortions in the economy.
With companies making much more use of investor-state litigation, a fresh risk arises that incentives, once given, cannot be withdrawn without inviting claims of expropriation and unfair and inequitable treatment – even if subsidies are available to domestic and foreign companies alike. The Czech Republic, for example, which followed a global trend by encouraging investment in solar technology, has been hit by a flurry of investor-state arbitration under the Energy Charter Treaty after it imposed a retroactive tax on the profits of solar companies.
More generally, the benefits of FDI seem to depend on whether they represent mergers and acquisitions (M&A) or “greenfield” investment, and what purpose the investment is serving.
In theory, M&A can help the destination economy by improving management and profitability (and hence the local tax base), with possible knock-on effects to the rest of the economy. In practice, it has long been known that the growth benefits of M&A FDI are modest if indeed they exist at all. If a foreign company is investing purely to gain market share, and if it repatriates profits to its parent company, the impact on the receiving economy is blunted. And evidence also seems to show that, to the extent that money enters the country and stays there, it will worsen the international competitiveness of existing firms by appreciating the real exchange rate.
Companies often engage in round-tripping – using subsidiaries to borrow in local capital markets and then lending back to the parent company. This adds to high private sector leverage and is likely to flow out rapidly in the event of a financial crisis, acting more like portfolio investment than FDI as it is commonly understood.
We should take care not to overstate the risks: there are no warning lights flashing red. For emerging markets, the share of greenfield investment in total FDI is above 70 per cent and changed little throughout the crisis (calculations from data here). Yet EMs’ rising share of overall global inward investment – from 36 per cent in 2007 to 54 per cent in 2013 – means that the stability of FDI is increasingly an EM issue. Economists at the UN say that FDI is now the biggest single external liability in developing economies.
This should be particularly concerning for deficit countries like Brazil and Turkey that have been relying on FDI to finance their current accounts. In Latin America, the income generated and repatriated from the existing stock of FDI has become almost as large as new FDI inflows, meaning that multinational corporations will no longer balance a current account deficit.
Indeed, though existing FDI is less likely to flee during a crisis, the flow of new investments is likely to dry up. In Turkey, for example, policymakers have always stressed that inward investment is a sign of confidence in the Turkish economy, with foreign companies wanting to use the crossroads between Europe and Asia as a production base for exports to the EU. Yet FDI to Turkey has dropped sharply since the financial crisis: UN data show it at $10.4bn as opposed to $28.9bn in 2007. And while the share of greenfield in the total last year was a healthy 92 per cent, it was much lower during the boom years of the 2000s when the current account deficit began to widen. In 2007 just 49 per cent of Turkey’s FDI was greenfield.
As emerging markets become a larger share of the world economy, it is unsurprising that they are taking a bigger spoonful of the FDI pudding as well. Yet as part of their preparations for the potential capital outflow as the US Federal Reserve continues to withdraw stimulus, policymakers would do well to remember that FDI is a liability that, one way or another, has to be repaid. FDI can be a helpful tool, but it is not a foundation on which an economy can unquestioningly rely.