Why are global FDI flows falling and what can governments do?

Global flows of foreign direct investment (FDI) have been declining for several years, well before the pandemic hit in early 2020. While these flows can be cyclical, as with any other type of investment, they have been falling both in absolute amounts and relative to overall GDP for several years, causing many to wonder whether there has been a structural change in the global economy. OECD’s Stephen Thomsen takes a look at this worrying trend and at what governments can do about it.

This decline in global FDI flows comes at a time when multinational enterprises (MNEs) are expected to do a lot of the heavy lifting to help governments worldwide meet the Sustainable Development Goals (SDGs). Beyond the capital MNEs bring to a country, new OECD indicators show that they can contribute to many different SDGs, such as job quality, productivity and innovation, gender inclusiveness or a country’s carbon footprint.

Figure 1. Are global FDI flows in long-term decline?

Notes: Based on the average of inflows and outflows. In principle, the numbers should be the same at a global level but there are often wide discrepancies.
Source:  OECD, FDI in Figures, October 2021

No consensus on why FDI has been falling

Theories abound for why FDI might be in long-term decline, if indeed this is the case. Some theorise that global value chains (GVCs) have reached their natural limits, faced with diminishing returns to hyperspecialisation. As with FDI trends, the GVC share of global trade peaked at the time of the global financial crisis. Similarly, and especially since the pandemic, some anecdotal evidence indicates that MNEs may be reshoring or near-shoring of their production, whether in response to supply shocks or because of the potential for greater scope for automation at home, although it remains to be seen how widespread this phenomenon is or what its impact will be on domestic jobs.

Others argue that MNEs are moving away from controlling relationships towards non-equity ways of collaborating which do not appear in FDI statistics. In a similar vein, the rise of technology firms with an asset-light approach to foreign investment implies less need for foreign affiliates. Some have looked at the falling returns on FDI, particularly in developing countries, as one possible explanation, although this begs the question of why returns might be falling. See, for example, the 27th Global Trade Alert.

Others look at the role of policy in explaining this decline. Policy uncertainty can be seen to be rising as political parties worldwide contemplate protectionist measures which raises the risk profile of potential projects. Rising uncertainty has been registered in several international indices, and investors routinely cite policy stability and predictability as an important factor in their investment decision. See, for example, the Global Economic Uncertainty Index.

Relatedly, some have argued that policy obstacles to FDI are rising worldwide. Over time, most countries have gradually liberalised their existing discriminatory regulations covering foreign investors, but there may be some evidence that this trend has slowed down or even stalled. The OECD Services Trade Restrictiveness Index finds that most policy changes in 2021 led to a decrease in FDI restrictions, although earlier years found increases in restrictions, while the OECD FDI Regulatory Restrictiveness Index has found little evidence of backsliding overall but shows the pace of reform has declined. The importance of existing restrictions might also be growing, as policy reforms in service sectors may not have kept pace with the growing economic importance of services and hence of service-related FDI. As for the impact of the rise in national security screening mechanisms, to the extent they might discourage FDI, this trend is too recent to explain the long decline in FDI flows.

Figure 2. Liberalisation of FDI restrictions has slowed down

Notes: Country coverage has increased over time which partly explains the recent increase in the non-OECD average. The Index covers only statutory barriers to FDI. Source: OECD FDI Regulatory Restrictiveness Index

More research is needed to understand what is behind this worrying global FDI trend, as it could adversely affect the ability of some countries to achieve the SDGs. It is important to point out that global trends mask considerable diversity across countries, with some such as Viet Nam or India doing relatively well even during the pandemic. Indeed, roughly one quarter of countries worldwide performed relatively well in attracting FDI in 2019. Furthermore, although global flows fell 38% during 2020 as the pandemic locked down the global economy, the rebound in the first half of 2021 was impressive, with global FDI flows in the first nine months of 2021 43% higher than in the same period in 2019. Clearly investors still have an appetite for foreign ventures.

Improving the business climate can increase foreign investment and help meet the SDGs

What is clear is that many host countries face an uphill struggle in attracting and retaining foreign MNEs, an effort which has become more urgent to confront the ravages of the pandemic. The good news is that governments are not simply passive spectators; they often have scope to raise FDI inflows through business climate improvements.

A good investment climate requires a whole of government approach, but there are some specific reforms that can clearly make a difference. Although many OECD countries are now relatively open to FDI and almost all countries have been liberalising gradually over time, many countries still discriminate against foreign investors, particularly in services. OECD research shows that removing these restrictions can raise FDI inflows. For a country like Indonesia with foreign equity limitations in many sectors, reforms which move policy towards that of relatively more open OECD countries could increase the stock of FDI in the economy by up to 95%.

Liberalisation should not be equated with deregulation. If anything, the removal of restrictions should be accompanied by better regulation in part to ensure that new investments occur in a framework in which any potential harm, such as to the environment, is mitigated. Better regulation can also help to maximise the impact of reforms on FDI inflows, as remaining behind-the-border regulatory barriers can sometimes undermine the potential for further FDI inflows. The multilateral discussions on investment facilitation will also yield further insights into how governments can encourage FDI in this area.

Going beyond FDI attraction, governments will need to pay more attention to the impact of such investment in terms of inclusive and sustainable development, particularly in a post-pandemic context. Recent OECD work on FDI qualities has looked at the policy levers to increase this impact in four areas: productivity and innovation; quality jobs and skills, gender and carbon footprint. Beyond government policies, there is a growing expectation that investors contribute to addressing climate change challenges and strengthen the sustainable impact of their activities in societies.

Governments clearly have the tools at their disposal to increase foreign investment in their countries with positive impacts on sustainable development. The risk is that a limited understanding of why FDI flows are so far below their 2007 peak will make this much harder. There is a lot at stake.


OECD FDI Qualities Indicators

OECD Policy Framework for Investment

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s