Risk and FDI
by Joseph Joyce
Risk and FDI
While FDI flows recovered in 2021 from the previous year’s decline, not all countries benefitted from the increase. UNCTAD reported that almost three-quarters of global FDI flows in 2021 occurred in advanced economies, and China and other Asian economies recorded the largest increases amongst the emerging markets and developing economies. Multinational companies are evaluating the course of the pandemic in those countries and their suitability for new global supply routes. Risk, always a factor in FDI decisions, has become an even more important concern.
There are, of course, many forms of risk. Neil M. Kellard, Alexandros Konotonikas and Stefano Maini of the University of Essex with Michael J. Lamla of Leuphana University Lüneburg and Geoffrey Wood of Western University examined the effects of financial system risk in “Risk, Financial Stability and FDI“, published in the Journal of International Money and Finance this year (working paper version here). They specifically investigated the impact of risk on inward FDI stocks within 16 Eurozone between 2009 and 2016, and used bilateral data drawn from the origin countries and host economies to compare the effects of different forms of risk in both locations.
Their results indicated that an increase in risk in the banking sector of an origin country—as measured by the proportion of non-performing loans—led to a decrease in FDI in the host countries. However, changes in bank risk in the host country had no similar impact. They interpret this result as indicating that multinationals are dependent on bank financing in their origin countries to finance their expansion.
In addition, inward FDI was negatively linked to upturns in sovereign yields in both the origin and host countries. The impact of the sovereign yield variable in the origin countries was larger than that of the corresponding yield in the host countries. They interpret the latter results as showing that an increase in sovereign risk in the origin country discouraged risk-taking by multinational firms based there, while the increase in risk in the host country caused multinationals to turn to other hosts. Moreover, when they separated the Eurozone countries into two groups, with Greece, Ireland, Italy, Portugal and Spain as the stressed group, they found that the size of the impact of the sovereign risk variables was comparatively larger in the stressed group.
Risk is also the subject of a recent NBER working paper by Caroline Jardet and Cristina Jude of the Banque de France and Menzie Chin of the University of Wisconsin-Madison, “Foreign Direct Investment Under Uncertainty: Evidence From A large Panel of Countries.” They examined host country “pull” factors and global “push” factors for inward FDI flows in a panel of 129 advanced, emerging market and developing economies over the period of 1995 to 2019. They focused on domestic and global uncertainty, using the World Uncertainty Index (WUI) and the Economic Policy Uncertainty Index as well as the VIX as measures of risk.
Their initial results indicate that the effects of uncertainty depend on the country group, and therefore they disaggregated the data. Domestic uncertainty does not appear to be a factor for any of the three groups, but global uncertainty as measured by the WUI has a large and significant negative impact on FDI in advanced and emerging market economies.
The authors also examined the impact of global financial factors on FDI. They initially used the real value of the Standard & Poor’s 500 index, and report that an increase in that measure is linked to increases in FDI in the advanced economies but declines in the emerging market and developing economies. The higher returns in the U.S. draw funds away from those prospective hosts.
Similarly, when they replace the S&P 500 with the nominal shadow Federal Funds rate or a world interest rate, they report that increases in either rate increased FDI in the advanced economies and lowered FDI flows in the developing economies. They suggest that this result reflects the existence of booms in the financial center countries that GDP data do not capture. They also reexamine the significance of the world uncertainty index as the different global financial variables are used, and find that the negative and significant impact holds up in the case of the emerging market economies.
Many types of risk, therefore, have an impact on FDI. Domestic financial risk in an origin country, for example, leads to less outward FDI by multinational firms based in that country. But firms are also affected by global uncertainty, and their response in terms of foreign investment seems to be most evident in the emerging market economies. Geopolitical tensions over Ukraine, the possibility of a new variant of the virus, and the prospect of higher U.S. interest rates all reinforce global uncertainty and complicate the decision over where to locate new investments.