by Joseph Joyce
The Rise and Fall of FDI
After the global financial crisis, international capital flows contracted, especially bank lending in Europe. Foreign direct investment (FDI) by multinational firms, however, provided a steady source of external finance, particularly for emerging market economies. The McKinsey Global Institute has calculated that the global stock of FDI increased from 46% of world GDP in 2007 to 57% in 2016 ($25 trillion to $41 trillion). But FDI flows fell by 27% in 2018 according to the Organization of Economic Cooperation and Development (OECD), and this drop followed a decline of 16% in the previous year. We have entered a new period of contraction by multinational firms, and in particular, U.S.-based multinationals.
A significant amount of the decline is due to firms based in the U.S. responding to changes in U.S. tax law. The U.S.-based firms repatriated earnings that had been kept abroad to avoid U.S. taxes. As a result, the U.S. recorded a negative FDI outflow of $50 trillion in 2018, down from a positive outflow of $379 billion in the previous year. By the latter half 2018, the acquisition of foreign assets had returned to positive levels, but the long-run changes of the tax code revision on the foreign operations of U.S. firms will only become clear over time.
Ireland and Switzerland were particularly hard-hit by the disinvestments, since these countries had often attracted FDI because of generous tax provisions. There were also reversals of investment in Special Purpose Entities (SPE), which allow the multinationals to channel funds through countries with favorable regulatory and tax practices to their ultimate destination. The OECD reported that FDI flows to SPEs in Luxembourg and the Netherlands fell to negative levels last year.
But the alteration in U.S. tax law is only part of a wider change in policy in the U.S. President Trump seeks to undo expansion by multinationals by persuading U.S. firms to return their operations to the U.S. During the last several decades, these firms and other multinationals used technological advances in communication and transportation to establish global supply chains of production. They located the production of intermediate goods in those countries where they were cheapest to produce before assembling them and exporting them to their final markets.
This expansion was facilitated by the establishment of stable macroeconomic and political conditions in the host countries where the production facilities were located. In many cases, these were emerging market nations, and their governments welcomed the investments of the multinationals, as the firms hired local labor and transferred capital and technology. Singapore, for example, has used its position as a financial hub and its reputation for pro-business regulatory policies to become a major recipient of FDI flows.
The establishment of production facilities in different countries has benefits and costs for home and host countries. But President Trump views this expansion only through the criterion of its impact on U.S. jobs, and he sees losses. He wants the U.S. firms to base their production in the U.S. where they will hire American workers. The President has frequently claimed that his use of tariffs and other tactics will re-establish manufacturing in the U.S.
Some U.S. firms were already responding to higher costs in China by shifting their supply chains elsewhere. But they often switch their operations to Vietnam and other low-wage countries, not the U.S. A policy of nationalism that forced firms to only operate here would require massive expenditures and higher costs for consumers. It would affect the ability of U.S. firms to export, since our exports often contain foreign components.
The Trump administration’s hostility to trade and outward FDI also affects inward FDI by foreign multinationals. These firms are often courted by state governments that want the high-paying jobs that they provide. Theodore H. Moran and Lindsay Oldenski of the Peterson Institute for International Economics and Georgetown’s School of Foreign Service have calculated that in 2013 the wages paid to the U.S. employees of foreign-owned multinationals exceeded those of U.S. workers of U.S. multinationals, which in turn exceeded those paid to workers in all firms by more than 10%. The U.S. and foreign multinationals accounted for 30 million workers, who in 2013 represented 22% of all jobs in the U.S.
But foreign firms have cut down on further expansion in the U.S. Foreign capital inflows to the U.S. fell from $509 billion in 2015 to $267 billion in 2018. Some of this downturn may have been cyclical, but foreign firms also have to consider the effect of tariffs on U.S. production. Adam Posen of the Peterson Institute for International Economics has warned “…that this shift of corporate investment away from the U.S. will decrease long-term U.S. income growth, reduce the number of well-paid jobs available, and accelerate the shift of global commerce away from the U.S.”
The decline in FDI last year reflected other factors than U.S. policy measures. While 2018 initially was characterized as a period of widespread growth, this expansion slowed during the year in response to instability in Turkey and Argentina, credit tightening in China, and other developments. This global slowdown in growth is expected to persist and the IMF forecasts economic growth in 2019 of 3.3%, down from 3.6% in 2018.
There is evidence that the rapid pace of expansion of the pre-global crisis has come to an end.The return on equity of multinationals has fallen from its pre-crisis peak. The ability of firms such as Apple to continue to post continued growth in global sales is being questioned. Governments such as India’s seek to protect domestic firms from foreign competition. Moreover, as pointed out above, China no longer is a source of cheap labor, and firms need to adapt to changing cost structures.
The immediate impact of the change in the U.S. tax provisions on FDI has most likely ended. But the fall-off in corporate expansion over the last two years is also a response to the changes in international trade and finance. The Trump administration has made clear that it wants to reverse the globalization of recent years, and the imposition of tariffs on Chinese and other goods will lead to a reorientation of business models. Over time this may be seen as the last gasp of a reactionary regime that was reversed under a future president. But the President’s Democratic challengers seem equally reluctant to support trade and expansion by U.S. firms. Until the status of trade in the global economy is clarified, multinationals will be reluctant to commit to foreign expansion.