“FDI, Open up!”

Recent global foreign direct investment (FDI) flow estimates show strong recovery efforts from the COVID-19 crisis in 2021. However, the global distribution trend shows that not all countries profit equally from FDI inflows. Developed countries have seen the highest growth rates of FDI inflow, but what does that mean for developing countries? More questions arise when considering outbound FDI statistics. As FDI flows are rebounding globally, it is remarkable that China’s outbound FDI is stagnating. Are national security concerns fostering protectionist tendencies, or how can we understand this trend turnaround?

But let’s start at the beginning: FDI always involves cross-border transfers of different assets. Usually, companies send direct investments to foreign countries to control the entity’s managerial control. The motivation of being in control is a decisive element of FDI. When a domestic company expands its business to a foreign country, it becomes a multinational enterprise (MNE). Figure 1 shows the two most common ways of FDI. The first is through Mergers & Acquisitions (M&A), which usually means buying (parts of) an existing foreign corporation.

On the other hand, greenfield investments stand for building new production sites or offices in a foreign country.

Figure 1. Types of FDI.
Graphic by Laurin Zils based on Graham, Edward M., Krugman, Paul R. (1993)

*Knock knock*

With the essential characteristics of FDI out of the way, one of the most relevant questions for outgoing direct investments is the “why?” question. Why would a domestic company invest large amounts of assets into a foreign country if they could also trade their goods and ship them to that country? This question might have been responsible for intensified research on FDI and the renowned economist Stephen Hymer was one of the first to come up with an answer. He dedicated his scholarly work to the concept and theoretically examined FDI in his dissertation published in  the year 1960. His dissertation provided one reason for the “why”: avoiding tariffs. According to Hymer, opening a subsidiary or production facility in another country can be considered a market entry strategy.

Figure 2: Possible motivations for outbound FDI. Graphic by Laurin Zils. 

Likely, a country’s openness to foreign trade resonates with the amount of inflowing FDI (of course, protectionist countries may also not allow inflowing foreign direct investments). Today, a variety of free trade agreements and joint economic trade unions exist that have led to abolished tariffs for traded goods between many countries. Thus, tariff avoidance may not be the prime motive for outgoing FDI today. Many reasons justify outflowing direct investments to other countries, as figure 2 shows. Firstly, there are economic motivations. Companies may build foreign production sites because of low wage levels and low tax levels in the area of investment. Often, foreign direct investment decisions motivated by low wage levels come at the cost of the workers – domestically and abroad. Closeness to the market can be an asset of high value for companies trying to enter a foreign market. Cultural differences and language barriers may make it challenging to advertise products from the headquarters. Establishing a marketing unit helps understand the local market, what messages work, and what messages you should avoid. Local marketers can also contribute to a better market understanding and faster trend identification.

Another valid reason to invest directly in a foreign site is the local workers’ expertise. Tesla, for example, is investing in a car production site in Brandenburg, Germany. Tesla’s CEO Elon Musk said that he appreciates the German engineering expertise and the ongoing transition  towards clean energy. This leads to the following possible reason: “homecourt”-advantage. Homecourt advantage is a sports term that describes having higher chances of winning if you play at home because you have the fans on your side. Being a local player, and most importantly, a local employer might increase your brand awareness and reputation. Products are often viewed more positively if the manufacturer provides employment locally. 

Lastly, some products or services cannot be exported. This holds for infrastructure projects. Think about the public call for bids regarding the 5G network expansion. These networks need to be built domestically. If foreign corporations want to enter the market, they need to make a foreign direct investment. The 5G network expansion will later serve as an example of the political dimension of FDI. Summarizing all reasons, companies’ motivation to place foreign direct investments in one word is simply revenue and growth.

Heterogeneous growth trends

Especially developing countries and “least developed countries” (LDCs), as referred to by the United Nations Conference on Trade and Development (UNCTAD), depend on FDI for infrastructure projects. Domestic financing for important infrastructure projects that are the basis for the growth of developing countries and LDCs is often not available, or at least not in completely sufficient amounts. 

The problem is, however, that the decision where FDI flows to, is primarily motivated by economic growth and revenue perspectives. Corporations will likely not invest in foreign infrastructure projects if they do not promise to be profitable in the future.

Infrastructure projects in developing countries and LDCs can be profitable. However, recent statistics of the UNCTAD show that developed countries benefited the most from FDI rebound effects after the COVID-19 pandemic. In total, FDI flows rebounded in 2021. While the global FDI flows in 2020 accounted for 929 billion USD, they rose to an estimated 1.65 billion USD in 2021, even surpassing the pre-COVID-19 level.

The FDI inflow to developed economies increased by a staggering amount of almost 200% from 2020 to 2021. On the other hand, the FDI inflow to developing countries only increased by 30%, respectively 19% to LDCs within the same time frame. The UNCTAD reports that the trend of the UN’s Sustainable Development Goals (SDGs) relevant investment projects in LDCs is even worse. After decreasing by 30% in 2020, the SDG projects in LDCs declined by another 17% in 2021. UNCTAD Secretary-General Rebeca Grynspan called the decline of new investments in LDCs “a major cause for concern.”

Come in, please

FDI has a capital sending and a capital receiving side. The capital sending side is one corporation that follows its interests. The capital receiving side should be considered as the country or region where the direct investment is made. FDI always includes a policy dimension. The policy dimension may be larger or smaller depending on the company and investment type. Referring to the earlier introduced Tesla example shows a case with a policy dimension, but a positive one. This foreign direct investment was a dream come true for the German government. Having Tesla build a gigantic factory creates jobs and increases economic growth. It is also a prestige boost and may lead to other companies following Tesla’s way.

When it comes to allowing or even attracting FDI, countries’ governments can take either a libertarian or a protectionist standpoint. Protectionist economies tend to reject FDI and free trade. Countries that are open to receiving FDI stress a variety of advantages, as figure 3 displays. However, the main motive of governments is economic prosperity. Research has shown that FDI positively influences economic growth.

Figure 3. Possible motivations for inbound FDI.
Graphic by Laurin Zils based on Rojec, Matija, Knell, Mark (2018) and De Mello Jr, Luiz R. (1997)

Privatization refers to the process of handing over public organizations to private-owned organizations. Many of these processes could be observed in formerly socialist countries on their way to a market-based economy, for instance the baltic states. After regaining independence from the former socialist Soviet Union, they transitioned to market-based economies. One vital characteristic of such is a large private sector. The baltic states needed FDI to overcome these transition processes, as they did not have enough means to do so internally. These means do not exclusively refer to financial resources. What the countries also lacked was technical as well as managerial know-how. With FDI, they managed to pull in financial resources and create so-called spillover effects. Spillover effects describe the transfer of knowledge from foreign companies to domestic companies, potentially fostering innovation.

Keep out

If FDI increases economic growth, innovation, the level of employment, and a country’s prestige, why should a government reject FDI at all? Two possible cases provide such reasoning. One is protecting the domestic economy, which could often be observed with socialist countries. However, countries with capitalist economies have rejected single FDI investments lately, as well. The reason behind rejections in such cases is usually to protect critical industries and the control over them and perceived threats to national security. The latter point of national security is connected with the defining element of FDI: control. As the companies maintain control over the corporations they invest in, it is worth taking a closer look at sectors crucial to national security or the supply of essential services.

It is interesting to note that Chinese outbound FDI has stagnated in 2021, although global FDI flows have rebounded. According to a report by law firm Baker McKenzie, China’s outbound FDI has even decreased over the past five years due to a “more complicated regulatory environment abroad (…) and increased foreign investment scrutiny from overseas regulators, particularly in the technology sector”. The report further states that Chinese outbound FDI to “less politically sensitive sectors”, like consumer products, has grown proportionally larger compared to sensitive sectors.

Adding to that, the German economy ministry has recently blown the foreign acquisition of the domestic company Siltronic. The Taiwanese company Globalwafers intended to buy the semiconductor company Siltronic in a deal that valued it at 4.4 billion Euros. Germany’s minister of the economy and vice-chancellor Robert Habeck intends to strengthen the European semiconductor industry while reducing the dependency on Asian manufacturers.

A trend turnaround?

Are we seeing a trend turnaround in global FDI because of increasingly high regulatory hurdles to protect domestic sectors and national security?

The earlier introduced example of the 5G network expansion in Europe is a sensitive sector. Telecommunication is an essential service. The integrity and security of the communication that runs via 5G must also be provided. Because of this, there has been a discussion between several NATO members, if the Chinese company Huawei should be granted access to the public call for bids. The concern is that Huawei might provide crucial information to the Chinese government. Huawei has denied having ties to the government and insists that its employees wholly own it. Could foreign intelligence services directly access European citizens’ communication? That is a scenario that should raise caution. Policy-makers are well-advised to take a closer look and take these concerns into account. Better safe than sorry.

It is up to the governments to implement healthy foreign investment policies. Because it is up to the institutions to maintain a healthy balance between investment inflow and fostering vital domestic industries, foreign direct investments can be an excellent chance for local, regional, and national economic growth. But you don’t want to open the door to everyone. If there is doubt about the integrity or if the whole package is not economically reasonable, the government should keep the door shut.

Laurin Zils
Staff Writer