Rising levels of inflation equate to rising prices of essential consumer goods and services such as food and fuel, and erode people’s and companies’ purchase power. It is little wonder then that inflation emerged as a top keyword in the first-quarter 2022 earnings calls analysed by Investment Monitor.
Earlier in 2022, both the US Federal Reserve and the Bank of England increased interest rates for the first time in years in an attempt to curb rising prices. The European Central Bank followed suit in June.
Inflation keeps on rising sharply in Western economies, and in the UK consumer confidence has sunk to its lowest level since 2008, raising concerns that the country may be sliding into recession.
All of the above makes inflation gain the status of a driver that multinational companies (MNCs) should carefully consider when selecting their next foreign direct investment (FDI) location.
Lasting inflation and FDI
The relationship between inflation and FDI is not straightforward.
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While high levels of inflation could be off-putting to foreign investors as they reduce the value of assets pegged to the local currency (as well as leading to currency depreciation in relation to foreign currency), moderate levels of inflation benefit foreign direct investors by helping to promote domestic growth, reducing the value of debts to suppliers and, via currency depreciation, increasing the competitiveness of exports.
The chart above draws data from the OECD and shows little correlation between rising inflation and FDI inflows.
The impact of inflation on foreign investment, however, seems to be more evident in those countries that fail to get it under control and end up experiencing prolonged periods of rising inflation.
Venezuela is arguably the worst case of continued rising levels of inflation, with its CPI index reaching a peak at nearly 32 billion per cent in January 2021.
Inflation in the country has been rising steadily since 2007, corresponding with a drop in FDI levels. Venezuela has suffered myriad issues in this time, however, so inflation will not have been the only driver to keep investors away, with political instability and social unrest in particular making it an unfavourable business location.
Argentina’s inflation has also been steadily on the rise since 2016, with levels of FDI flows also proving volatile during this period.
The sectoral impact of high inflation
As well as the impact it has on consumer prices, inflation has a broader influence on prices rising across the board and in specific sectors.
In the UK, for instance, the increasing cost of raw materials is damaging the construction sector, making it less attractive from an FDI point of view too.
The chart above shows how as inflation rose in Argentina, construction projects declined.
While inflation seems to be harmful to foreign investment mostly when sustained at high levels over a number of years, current trends in Western economies are not encouraging and should urge MNCs to continue to keep a watchful eye on inflation levels during their site selection process.
This article is part of a series focusing on FDI drivers that are rising in importance in the post-Covid environment. The full list comprises: