Foreign direct investment in emerging markets has plunged to its lowest level this century as mounting trade tensions build on weakening economic growth in the developing world.
FDI, which involves buying companies and building new facilities, fell to just 2 per cent of gross domestic product across emerging and frontier markets last year, according to the Institute of International Finance, which tracks cross-border capital flows. This compares with a peak of 4.4 per cent in 2007, immediately prior to the global financial crisis, as the first chart shows.
The trend, which could further sap weakening economic growth in emerging markets, plays into a narrative of declining globalisation at a time when growth in global trade is also juddering to a halt.
“FDI fell particularly strongly last year as trade policy uncertainty escalated, but also as part of a broader retrenchment of all types of capital flows in the context of the spike of risk aversion, especially in the fourth quarter,” said Guillermo Tolosa, economic adviser at Oxford Economics, a consultancy.
Murat Ulgen, global head of emerging market research at HSBC, who forecast FDI flows would tumble to just 1.5 per cent of EM GDP this year, added: “Given the lingering concerns about global economic activity on the back of rising trade tensions, FDI flows are likely to remain weak in 2019.”
Sergi Lanau, deputy chief economist at the IIF, believed a series of factors had conspired to cause a “secular decline” in FDI in emerging markets since the financial crisis, whether measured in traditional terms or in “true” terms — stripping out reinvested earnings to focus on “new” investment flows — a metric the IIF prefers, illustrated in the second chart.
First, rising commodity prices boosted investment in mining FDI, “which in some countries accounts for a very large share of total FDI,” in the immediate aftermath of the crisis. However, this has fallen back, in line with commodity prices.
Second, Mr Lanau said the 2000s “were a period of strong growth for developed market banks, which invested heavily in subsidiaries in EM”. However, “the world looks very different now for banks,” he added.
Third, significant house price increases in emerging markets between 2003 and 2007 led to a rise in real estate-based FDI, “a major category in many countries”.
All three factors “have a lot to do with a period of exuberant asset prices across the board in the run-up to the global financial crisis,” Mr Lanau said, while “years of quantitative easing and low interest rates have encouraged hot money flows to EM,” giving an advantage to portfolio investment over FDI.
“It is not clear to me that these factors are set to reverse any time soon. If anything, growing trade tensions and nationalist political forces around the world will make a turnaround in FDI to EM more difficult,” he added.
Mr Tolosa argued there was a strong correlation between FDI inflows into emerging markets and the degree to which EM economic growth outstrips that of the developed world, a differential that has tumbled from 6.1 percentage points in 2009 to just 2.3 points last year, shown in the third chart.
“FDI to emerging markets in terms of EM GDP has been falling since 2008, in line with the systematic fall of the growth differential of EM and advanced markets,” Mr Tolosa said. “As EMs have become relatively less dynamic, it makes sense they receive less investment.”
In addition, he argued that the opportunities from fiscal or labour arbitrage have declined, while investment has also become more “asset-lite”, meaning fewer dollars are needed for a given impact.
Mr Ulgen suggested rising levels of emerging market corporate debt and higher debt servicing costs may be deterring cross-border merger and acquisition activity in EMs.
He also pointed to tumbling rates of return for foreign direct investment in the emerging world. Returns fell from 10 per cent to 8 per cent between 2012 and 2017, according to Unctad, the UN’s trade and development arm. This is twice the rate of decline in developed markets, as depicted in the final chart, even if returns remain higher in EMs in absolute terms.
The worsening Sino-US trade war may be another factor weighing on activity. Mr Tolosa noted that the share of inward EM FDI going to China has fallen from a high of 43 per cent in 2015 to 37.3 per cent last year
This is despite China becoming significantly more open to FDI flows, according to the OECD’s FDI Regulatory Restrictiveness Index, “so the most likely reason for falling flows is trade policy uncertainty,” Mr Tolosa said. “Half of US FDI into China is into the manufacturing sector, which is mostly linked to trade.”
Mr Lanau offered a ray of hope, saying “some would argue that in a world where China isn’t open for business, a lot of FDI would go elsewhere in Asia to redesign supply chains”.
There is some evidence of this happening already as lower value-added manufacturing is increasingly shifted to lower wage Asian economies to escape rising labour costs in China.
The share of emerging market FDI flowing into Asia ex-China has risen from 11.9 per cent in 2011 to 19.6 per cent last year, according to the IIF’s figures, with the likes of the Philippines seeing steep rises, admittedly from a low base.
More recently, Vietnam reported that stake purchases and pledges for new foreign direct investment rose 81 per cent to $14.6bn in the calendar year to April 20, compared with the same period in 2018.
Mr Lanau was doubtful this trend could make a serious dent in the EM-wide FDI drought, however.
“It may happen to some extent but I personally subscribe to the school of thought that in a serious trade war where investing in China becomes difficult, there would be few or no winners,” he added.