Wrong way round

Jun 27th 2005
From The Economist Global Agenda

Foreign direct investment is beginning to flow in the right direction: out of slow-growing wealthy countries and into emerging markets. But overall, capital is still moving from the developing world to the developed—and, in the process, helping to increase the imbalances that put the world economy at risk

LOCAL politicians love foreign direct investment (FDI) above almost all else. Nothing burnishes political fortunes quite so brightly as persuading some overseas investor that in the whole wide world, there is no better place to make his products than right here in our hometown.

Showy projects beloved of local politicians are often the bane of economists, but in this case the dismal scientists agree. FDI, which includes things like mergers, acquisitions and companies building factories abroad, functions as a sort of seal of approval on the political and economic practices of developing economies, and deepens the integration of global markets. It also increases economic growth—by one estimate, a one-percentage-point rise in the ratio between the stock of FDI and GDP in developing countries raises output by 0.4%. In general, foreign-owned companies perform better, and pay higher wages, than local ones.

Given all that, it is not surprising that the level of FDI in the world is a closely watched statistic. The mostly wealthy countries that belong to the Organisation for Economic Co-operation and Development (OECD) are the world’s biggest source of FDI. They saw their FDI flows explode in the late 1990s, driven by a stockmarket boom that spawned a vast litter of cross-border mergers. But after peaking in 2000 at more than six times their 1991 level, both outflows and inflows dropped dramatically. A new report from the OECD shows that total FDI outflows from OECD countries were well below their 2000 peak in 2004, at $667.8 billion, while inflows were just over $400 billion.

The good news is that investment is starting to grow again. With continued recovery in countries like America, which boosted investor confidence, 2004 saw FDI outflows at last begin to increase after a three-year slump. America was the largest provider of funds, with outflows of $252 billion. It also regained its status as the largest recipient, a position it has held for most of the past two decades. But the recovery in America’s investment inflows was not enough to stem a general decline in the OECD, thanks to weakness in continental Europe, particularly Germany and France.

The biggest development, however, is that FDI is increasingly starting to flow out of the OECD, rather than between its members. Net outflows from the OECD have been rising since 2000, when they actually dipped into negative territory as merger mania hit its frenzied heights. In 2004, the amount of money invested outside the OECD reached its highest levels in over a decade, as rich-world investors sought cheap labour and untapped consumer markets in the developing world.

China, where this combination is particularly enticing, has played a key part in this trend. Its FDI inflows have been regularly setting annual records, and 2004 was no exception: China recorded $54.9 billion flowing into the country, while only $1.8 billion flowed out. But other regions have also benefited from the boom. South America, and Argentina in particular, seems to be bouncing back from a slump. And direct investment in India is growing rapidly, albeit from a very low level.

A glut of savings

The flow of funds to the developing world is particularly good news in the context of a new theory that is emerging to explain America’s gaping current-account deficit, which reached 6.4% of GDP in the first quarter of 2005—a level that is clearly unsustainable over the long term. Economists are worried that the inevitable adjustment will be “disorderly” (read “catastrophic”), which would have dire consequences for a world that has grown far too dependent on import-consuming Americans to drive its growth.

Thus far, policy prescriptions have focused on reducing America’s gigantic federal budget deficit and increasing its paltry household savings rate. But economists like Ben Bernanke, a governor of America’s Federal Reserve, point out that neither the budget deficit nor changing attitudes toward saving can explain the deteriorating fiscal position; experience in America and other countries indicates that current-account and budget deficits are not tightly linked, and household savings should be increasing as the Baby Boomers near the age of retirement. Mr Bernanke argues that the recent increases in the current-account deficit are in fact the result of a global savings glut pouring out of the developing world. This onrush of capital is fuelling the low interest rates and rapid asset-price appreciation that turn frugal consumers into spendthrifts.

But why are poor countries so willing to lend the rich world money? In theory, the flows should run the other way, from wealthy countries where growth is slow, to developing nations where potential returns on capital are higher. Glenn Hubbard, a former chairman of President George Bush’s Council of Economic Advisers, argues that the culprit is weak financial systems; countries with poor investor protections, fragile equity markets and shaky banks offer few attractive opportunities for domestic savers. Government policies are also to blame, such as China’s machinations to keep the yuan weak, which forces it to buy massive amounts of dollars that are then invested in American securities.

Thus the news that FDI, at least, is running in the right direction is welcome. But by itself, it will not be enough to stem the flood. FDI is harder to arrange than loans or securities issuance because, with only a limited role for middlemen, principals must do a lot more work and put up a lot more money. This tends to limit the scope of FDI to big projects in relatively big markets, where foreign investors can expect big returns on their money. As for local politicians, so for national ones: as good as FDI is, it is no substitute for getting the financial house in order.

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