FDI in a Risky World

by Joseph Joyce

FDI in a Risky World

The pandemic has shown that global supply chains are vulnerable to shocks. Output contracted as factories were closed in China and the impact was transmitted to firms further along the chains and the distributors of the final goods. Foreign direct investment had already slowed in the aftermath of the global financial crisis of 2008-09, and there were questions about its future (see here). How will multinational firms respond to the new shock?

The McKinsey Global Institute seeks to answer this question in a new report, Risk, Resilience and Rebalancing In Global Value Chains. The authors point out that the pandemic is only one of a range of shocks that can disrupt production. They distinguish between catastrophes that are foreseeable (such as financial crises) and those unanticipated (acts of terrorism), as well as disruptions that take place on a smaller scale. The latter can also be divided between those that are foreseeable (climate change) and those that are unanticipated (cyberattacks).

The report then measures the exposure of different business sectors to the various shocks. Those that are heavily traded are more vulnerable. These include communication equipment, computers and electronics, and semiconductors and components, all industries that are seen as promoting growth. Apparel is another sector that is vulnerable to risks, such as the pandemic and climate change.

These risks will motivate firms to reconfigure their supply chains. The political fissure between China and the U.S., as well as government policies to ensure self-sufficiency in some sectors, will also induce firms to reorganize production. The report’s authors estimated that 16% to 26% of current exports could be shifted. They find that “…the value chains with the largest potential to move production to new geographies are petroleum, apparel, and pharmaceuticals.” In some cases governments may need to provide financial support to induce firms to relocate to domestic economies where the governments seek domestic self-sufficiency.

The United Nations Conference on Trade and Development (UNCTAD) in its World Investment Report 2020 also considers the future of FDI (see here for a summary). It identifies three trends that will shape the future of international production. These include technology trends that contribute to a “New Industrial Revolution;” growing nationalism that leads to more protectionism; and the need to achieve sustainability.  As these forces evolve, they will push firms to increase supply chain resilience and increase national and regional productive ability.

The authors of the UNCTAD point out that economic sectors differ in terms of the length of their existing value chains, their geographical distribution, and their governance. Consequently, multinational firms will respond in different ways to the trends the authors identify. But they identify three overall trajectories–reshoring, regionalization, and replication–that all involve scaling down global value chains. A fourth trajectory–diversification–would transform existing operations but include a lower geographical distribution of value-added and less investment in capital goods.

These changes represent challenges to government policymakers, particularly those in developing economies. A retreat of international production will hamper the prospects of lower-income countries where the global supply chains have been a driver of growth. But there is also the opportunity to attract new investment. Among the measures that the report’s authors recommend are investment promotion strategies in infrastructure and services, and participation in regional initiatives.

The reconfiguration if international production systems will shape FDI in the years to come. But the formation of new production chains will only take place as the global economy recovers from the current collapse. UNCTAD reports that global FDI flows are forecast to fall by up to 40% in 2020 from their 2019 value of $1.54 trillion, and could decline by another 5% to 10% in 2021. All these predictions come with large degrees of uncertainty about the future of the global economy. Multinational firms will hold back on new expenditures until they see a consistent recovery and learn how governments will seek to influence their foreign operation.