Emerging world needs the right kind of FDI

Foreign direct investment into emerging markets rose again last year from already historically high levels, with east Asia driving the increase. Moreover, outward FDI from emerging economies increased by a third, with Hong Kong and mainland China together becoming the second biggest source of outbound investment.

Good news from the UN’s flagship World Investment Report in an otherwise gloomy EM economic landscape? Not quite. The overall increase reflected a rise in mergers and acquisitions (M&A) activity rather than greenfield investment, meaning it may say more about financial conditions than prospects for growth. And China’s shopping spree abroad partly reflects the dearth of opportunities at home.

It has long been an idée fixe among EM policy makers that foreign direct investment is to be encouraged. All sorts of policy instruments — relaxing M&A restrictions, targeting subsidies, special economic zones with lower taxes and looser labour laws, signing bilateral investment treaties — have been tried to attract multinational companies.

However, although there have been some spectacular successes — China’s export-oriented development relied heavily on foreign companies in its early stages — not all FDI is equal. M&A, though it may bring with it management expertise and new technology, does not add to the productive stock of capital of the recipient country. Greenfield investment is generally considered more useful for growth and development purposes.

Here, the picture is less impressive. The UN figures show that the value of cross-border M&A rose in developed economies by 16 per cent but in developing and emerging economies by 66 per cent. But the global total of announced greenfield investment projects fell by 2 per cent, with that in developing economies sliding by 1 per cent and transition economies experiencing a big fall of 13 per cent.

Moreover, more timely data from fDi Markets, an FT data service, show a fall of around 25 per cent in greenfield investment in the first quarter of 2015 compared with a year ago. It would appear that the general air of malaise in the emerging world, with growth weakening and trade sluggish, has also fed through to cross-border investment.

That said, those emerging markets that have a convincing story to tell are still capable of attracting substantial amounts of greenfield FDI. One of the most interesting countries to watch is India, where Narendra Modi, elected as prime minister last year, has declared a renewed push for FDI under the domestically oriented slogan “First Develop India”. The fDi Markets data showed a surge in investment into the country in the first quarter of 2015.

Inward investment has long been a political bone of unusually vigorous contention in India, where it is associated with environmental and social degradation by its vociferous opponents. And the resistance Mr Modi has faced shows the difficulties of attracting the right kind of investment.

To the prime minister’s credit, he has managed to liberalise parts of the service sector such as railways and insurance. Yet it remains much easier to invest in most of the manufacturing sector in India. Other parts of the service sector where FDI might deliver large productivity gains, notably retail, have been strongly resistant to liberalisation, particularly at the state level where many decisions are taken. In theory, the previous Indian government liberalised so-called “multi-brand” retail; in practice, hardly any large-scale investment has taken place.

The relevance of this is that the traditional east Asian-style development model, led by manufacturing exports, has broken down within the emerging world. What Dani Rodrik, the Harvard development economist, calls “premature deindustrialisation” has led to countries’ manufacturing sectors shrinking in relative terms at much lower levels of per capita income than for previous waves of industrialisers.

True, there are some countries that are following the traditional route, such as Vietnam, which not coincidentally has one of the highest rates of net FDI inflow relative to GDP in the emerging world. But it seems highly likely that FDI in other developing markets will be more effective in increasing overall productivity and investment if it is concentrated in services.

Traditionally, it has been politically harder to liberalise FDI in sectors that serve the domestic market: it is much more difficult to overcome the resistance of thousands of small shops to competition from Walmart than it is to fence off a stretch of coastline and invite in manufacturing exporters.

Accordingly, the struggle to expand economic capacity by attracting FDI in many EM countries is likely ever more to depend on governments’ ability to face down domestic opposition. Governments can sign (increasingly controversial) investment treaties with their trading partners to try to bind their hands domestically when it comes to treating companies from overseas. But existing regulations and political and social opposition can push them in the opposite direction.

Seen this way, the weakness in FDI is simply another facet of the general problem in the EM world: mistakes in macroeconomic policy that lead to recessions or slowdowns in the shorter term and too little economic reform to spur long-term growth. Policy makers can fiddle about with specific FDI incentives all they like: the challenge is to open domestic markets to foreign competition from inside their borders.