Foreign direct investment (FDI) flows – save for a brief recovery in 2021 – are in decline. Since their record high in 2016, FDI flows are on a downward trend, a development even more pronounced if we merely look at greenfield projects. Apart from several semiconductor and electric vehicle battery projects, the situation looks gloomy, in particular for the least-developed countries. Over the past decade their measly share of approximately 2% of global FDI continues to decline – in absolute numbers as well as in share of gross domestic product.
Protectionism and regulatory overshoots in the name of national security increasingly erode investor confidence and risk appetite. Rather than pointing to asset-lite FDI, we would argue that we are witnessing a structural decline of FDI as a result of over-regulation and protectionism. We are certainly not advocating a Friedmann-esque surge of deregulation but instead a simplification and streamlining of regulatory guard rails. Otherwise, the current trend of corporates not considering FDI a worthwhile endeavour due to overly complex procedures will persist.
We therefore seek to pinpoint some of the new realities that make it too complex for corporates to engage in FDI, look at current developments and corporate reactions, and attempt some initial suggestions for a rebalancing.
Are we really having a problem, or is this merely an accounting fluke?
One of the problems with FDI figures is that they rarely tell the full story. One of the biggest problems is that inflows into some countries have little to do with genuine investment into the location – at least if we conceive investments in terms of employment or production equipment.
Countries such as Luxembourg, Mauritius, Bermuda and Cyprus merely act as conduits, channelling investment towards their final destination (so-called ’round-tripping’).
Does BEPS II have something to do with it?
The short answer is ‘yes’. BEPS II (the OECD’s base erosion and profit-shifting initiative) is the global minimum tax reform aim to curb multinational company profit shifting and tax avoidance. By introducing a minimum tax, FDI projects predicated on tax optimisation will dry up. This is not to say that this is a problem but it will be visible in the statistics.
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It is estimated that in a baseline scenario, overall global FDI will decline by around 2% and a significant shift in FDI flows and destinations is set to ensue.
The overall international atmosphere
Geopolitical tensions and an anti-globalisation sentiment undoubtedly play a major role in the persistent decline of FDI flows. Donald Trump’s ‘America First’ policy, Brexit and tensions between the US and China have led to a significant rise in trade and investment uncertainty. Long-term plannability – so crucial for FDI projects – is largely seen to be a thing of the past. The global rise in protectionism is a response to bubbling nationalist sentiments, swinging domestic political situations. This frequently results in the imposition of tariffs or local content requirements.
This coincides with a historically unprecedented weakness of the UN, the World Trade Organisation (WTO) and other such institutions.
In the early 2000s, governments sought to streamline and reduce excessive regulation, as this was seen as a barrier to FDI attraction, something which benefitted small and medium-sized enterprises in particular, which typically lack the know-how and resources to operate in a complex, high-regulation context. However, post-2008, and especially post-Covid, under the banners of fairness, national security and good governance we are seeing a resurgence of regulation. While in principle this is a necessary set of guard rails to level playing fields for all, we are currently in regulatory overshoot.
We should therefore seek to establish a global consensus on these four key areas:
- Punitive or protective tariffs (curbing measures designed to protect domestic manufacturers vs. measures created to establish a level playing field as in the carbon border adjustment tax).
- Trade and investment policies (curbing measures designed to limit exports or investment, mostly under the heading of national security or sovereignty – from face masks during Covid to semiconductor chips – vs. creating easy-to-understand rules of the game).
- Tax reforms (either in terms of seeking to align global tax rates, or in some developing countries to streamline the highly opaque tax systems that are often enough designed to open up ‘policy space’ for local politicians).
- The rise of ESG (environmental, social and governance) and the increase of worker compensation legislation (in erstwhile low-labour-cost countries, minimum wage legislation, social security hikes and a mandated increase of vacation days are affecting investor balance sheets).
While most of the underlying objectives driving such measures are legitimate, the current regulatory context is starting to change the business model of low-labour-cost FDI and shifting investment streams.
Protectionism (with a small ‘p’)
Small ‘p’ protectionism denotes national regulatory measures, largely within the remit of WTO standards.
Due to numerous recent changes in regulatory regimes, and due to boundaries between regulation and protectionism becoming increasingly fluid, the corporate sector is getting unsettled. Avoiding such haziness is in fact becoming a location choice factor (according to the 2020 World Bank Global Investment Competitiveness Report, for which 2,400 business executives were interviewed, it isn’t low taxes or low labour costs that are now considered to be the most important location decision factor but ‘political and economic stability’ and ‘a predictable legal and regulatory environment’). This arguably reflects the fact that managers are seeking reliable and plannable frameworks but are increasingly perceiving this area as a risk.
With FDI being the prime example of sunk cost projects, managers react acutely to regulations that result in cost increases. Worse still, regulatory measures can limit market or raw material access, or even exporting or re-exporting possibilities.
Such regulatory changes increasingly stem from a new zeitgeist, one that is driven by ESG and supply-chain legislation. Irrespective of how well meaning these might be, they are beginning to have a significant impact.
Given the underlying good intentions of these pieces of legislation, we separated small ‘p’ and large ‘P’ protectionism. It is not necessarily the case, however, that all of these measures impact corporate bottom lines. Research is unequivocal about this: reducing regulatory risks and burdens for investors consistently increases the likelihood and volume of FDI flows, and vice versa.
Protectionism (with a big ‘P’)
Big ‘P’ protectionism is the realm of tariffs and measures beyond WTO standards. It is no secret that FDI regulations are being tightened around the world. One of the most strident countries in this regard is the US, which has passed the Foreign Investment Risk Review Modernization Act (better known as FIRRMA) and the trade-related equivalent, the Export Control Reform Act. Sectors warranting special investigation on account of national security – not only for the US, but most Western countries – today include pharma, biotechnology, AI, robotics, quantum computing, semiconductors and micro-electronics, critical minerals, aerospace, and all aspects of military production. Accordingly, the number of investigations under US FDI screening rose from 25 in 2009 to 130 cases in 2021.
Another area for large P measures, mostly used by developing countries and emerging markets, is capital controls to restrict capital inflows and protect domestic banking systems (cheap foreign loans vs. much higher lending rates in the home market, which is what has happened in India). While long seen as an impediment to functioning markets, the International Monetary Fund recently radically changed its view on capital controls, and now considers them “an appropriate instrument for achieving macroeconomic and financial stability”.
The large-scale shift towards renewable energy and battery technology is changing the power balance for a number of countries supplying rare earths or minerals. This new-found power is used quite liberally by some countries, curbing market access or the flow of goods. Indonesia, one of the world’s biggest exporters of nickel, recently banned the export of the unprocessed nickel ore, insisting on domestic processing and refining. Similarly, Zimbabwe, the largest lithium producer in Africa, is banning the export of lithium as of January 2023, also insisting on cornering the market for processing.
For several decades, the default position (or, admittedly, the rhetoric) was ‘globalisation is good for us’, although we have to admit that some of the most strident advocates of the Washington Consensus also employed strong industrial policy measures. Increasingly we are seeing a trend towards economic fragmentation, decoupling and notions such as ‘economic sovereignty’.
One of the most visible policy outcomes of this is the concept of ‘friend-shoring’, prominently outlined by Janet Yellen (the US Treasury Secretary) in early 2022. This is where FDI flows are determined more by geopolitical alignments than pure business logic.
Germany, one of the most active global players in outward FDI, is now investing primarily within Europe and the US. China and Russia – for a long time important partners for the German economy – are rapidly losing relevance as German outward FDI destinations.
In conclusion, the slowdown in FDI flows (and the partial rerouting of investments) should not come as a surprise. Similarly, the new-found corporate interest in transparency, and in regulatory and political stability, are a rather predictable reaction.
Most importantly, however, FDI in the current economic and political climate is increasingly not worth it anymore (the risk-reward ratio). Rising ESG demands and labour costs in former low-labour-cost countries coincide with a surge in automation in core markets. The growing risk for investing in far-off countries coincides with consistently falling average returns on FDI projects. Companies just don’t feel it is worth it anymore.
Driven by a plethora of geopolitical developments, business models are changing dramatically. FDI played a significant role for developing countries as a key source of capital inflow. However, it was never an end in itself but instead a means to generate profit. Even if corporates today are far more stakeholder oriented than in the past, businesses are only in business as long as they earn a decent return on their invested capital. If we want FDI flows to return, we need to make it work for all sides.