The global economic downturn coupled with current military action by the US could give emerging market countries a financial headache. Steadier than other forms of investment in uncertain times, FDI could restore them to health, says Charles Piggott.

For the first time in more than a decade, global foreign direct investment flows are shrinking. Even before the terrorist attacks in the US, global foreign investment flows were set to slump by 40% this year to $760bn from last year’s record of $1300bn. However, much of the slowdown is accounted for by the end of the merger and acquisition boom in developed countries. Meanwhile, stable FDI flows to developing countries could prove an economic lifeline.

Fears of a sustained FDI recession may be overdone, according to a recent survey by management consultancy group AT Kearney. In the immediate wake of the first terrorist attacks, AT Kearney asked leading multinationals whether their overseas investment plans had changed. Two-thirds indicated that they still intend to invest overseas at approximately the same levels as last year (see charts).

Even though nearly 95% of the CEO-level executives surveyed in the weeks following September 11 were more concerned about the health of the global economy than they were one year ago, roughly 16% intend to increase investment overseas compared with last year. However, 20% intend to scale back overseas investment.

Steady progress

Paul Laudicina, head of AT Kearney’s Washington-based global policy unit, which conducted the research, says the survey shows most CEOs intend to take a “steady-as-they-go” approach to overseas investment. Mr Laudicina adds: “FDI decisions are typically more sober than other forms of investment, and multinationals are not likely to change their course unless there is a dramatic reversal in the [economic and political] environment.”

According to AT Kearney’s survey, most CEOs still regard US and European economic health as one of their greatest concerns when making investment decisions. However executives expect US-led military action to have a greater impact on investment decisions than, for example, energy price volatility, Japan’s economic recovery, future trade rounds or the launch of the euro.

Other points raised by the survey include a negative turn of investor sentiment towards the US. In the past four years, previous surveys showed that investor sentiment towards the US had grown increasingly positive. But, in the wake of the attacks, nearly one-third of investors surveyed had a more negative outlook on the US as an investment destination than one year ago. China is the only major country to experience a positive shift in investor sentiment in the past year.

Rising uncertainty in the wake of the terrorist attacks and a slowing global economy will stem flows of cross border investment. Even before the crisis broke, there was already clear evidence of a slowdown in foreign direct investment flows. As early as February 2001, the Economist Intelligence Unit (EIU) forecast global flows of FDI would recede significantly in 2001, marking an end to a decade of extraordinary growth in FDI.

Since then, forecasts from the United Nations Conference of Trade and Development (UNCTAD) and other organisations have confirmed that global flows of FDI are slowing. This year’s 40% fall in cross-border direct investment will be the first decline since 1991, when a global recession caused a 23% drop in international investment.

M&A warps figures

However, these figures may be misleading. Mr Laudicina believes that major developing countries will continue to attract multinational investors: “Excessive M&A activity in 1999 and 2000 has blurred the picture of what is happening in terms of FDI flows. More than anything else, these figures primarily reflect an end to the mergers and acquisitions boom in developed countries.”

The extraordinary M&A activity of 2000, which included mega-mergers such as VodafoneAirtouch’s record $165bn takeover of Mannesmann, has not been repeated in 2001. Lower share prices have made M&A harder to achieve and so far this year the biggest cross-border deal has been Deutsche Telekom’s $24.6bn takeover of VoiceStream in the US. Until share prices recover from their current retreat, cross-border M&As (and consequently FDI levels) are unlikely to match their 2000 peak levels.

Although the economics of cross-border acquisitions may have changed, the long-term economics still favour other types of overseas investment, particularly investment in greenfield projects. In the past two decades, foreign investment levels have increased dramatically as companies have relocated their production facilities overseas. In 1982, global flows of foreign direct investment stood at just $57bn, compared with the record $1300bn in FDI flows in 2000. In the same period, multinationals’ overseas operations grew in value from less than $2000bn to more than $21,000bn.

FDI drivers

Although uncertain global political stability and economic growth will affect FDI levels, other drivers of direct investment, for example market size, infrastructure, human skills and natural resources, are unlikely to be much affected.

Says Karl Sauvant, UNCTAD’s director in charge of the institution’s definitive annual World Investment Report: “We expect the longer-term trend of rising levels of foreign direct investment to continue. The driving factors behind this trend are economic liberalisation and technological innovation that enable global and regional networks to develop.”

Mr Sauvant says the fundamentals that drive FDI did not change on September 11: “As long as there is no change in these fundamentals, the trend of rising FDI will not be reversed.” Mr Sauvant believes domestic competition alone will force multinationals to continue to invest overseas.

In the past decade, competitive pressures have forced multinationals to diversify across borders to reduce production costs and to access previously untapped markets for their products.

Although the threat of terrorism may make international travel less easy for multinational executives, Laza Kekic, an economist specialising in foreign direct investment at the EIU in London, does not believe there is a significant setback to the trend of globalisation: “Will there be fundamental changes in the way businesses operate after September 11? I don’t really see this happening. So long as the business environment remains competitive, companies will still want to relocate production to countries such as China.”

Mr Kekic says 2002 may be a lacklustre year in terms of FDI flows to emerging markets, but that direct investment flows will start to recover some time in the second half of the year. He says: “The big drop in FDI in 2001 was largely confined to developed countries. FDI flows to emerging markets in the first three quarters have been relatively stable.”

Q3 forecasts

Before the crisis, it looked as if central and east European countries would be largely unaffected by the global downturn in FDI. At the end of the third quarter, FDI flows to the region were forecast to reach $27bn in 2001, the same level as for 2000. However flows to Latin America and the Caribbean were forecast to fall from $86bn to $80bn, while flows to Asia and the Pacific were forecast to fall from $144bn to $125bn. Africa is the only region forecast to receive higher FDI flows in 2001 than in 2000, with FDI flows of $10bn forecast for 2001 compared with $8bn the year before.

Although FDI will be hit by any downturn in the world economy, positive changes in attitude towards foreign investment have encouraged many developing countries to push onwards with economic liberalisation. Russia, for example, has so far been unsuccessful in attracting large flows of FDI, but has made significant progress this year in reducing barriers to foreign investment.

However, the most positive change this year has been agreement on China’s entry into the World Trade Organization (WTO). Depending on how long it takes China to ratify WTO accession, it could join before the end of this year. The country will then have five years after its official accession in which to liberalise its laws on trade and investment in line with WTO rules. Already China has seen a rise of slightly more than 20% in FDI in the first six months of 2001 to $20.7bn in anticipation of its WTO entry. This growth in investment is expected to continue as companies relocate production to China to reduce costs. In AT Kearney’s recent investment poll, China registered the biggest positive shift in investor sentiment.

Green light

Although direct investments in many emerging market countries risk postponement in the light of greater political and economic uncertainty, many existing plans are still going ahead. For example, there is continued speculation that Japanese car manufacturer Toyota plans to build a production centre in Mexico by 2004 to take advantage of the elimination of tariffs and trade restrictions under the North American Free Trade Agreement. Other cross-border investment projects that appear to be on track include the $3.5bn pipeline project involving TotalFinaElf of France to pump gas from Qatar to Abu Dhabi and Dubai.

Chris Vermont, head of project and structured finance at ANZ Banking Group in London, says while some deals are still going ahead, others have been put “on ice”. He adds: “Developing market deals are still being done, but there will be more questions asked in credit committees and, in general, a heightened awareness of risks.”

Even before the current crisis, rising doubts over the strength of the world economy had caused multinationals to withdraw their overseas investments. So far this year, headline examples include Exxon Mobil’s closure of a liquid gas plant in Indonesia, J Sainsbury’s closure in Egypt, and Clorox’s withdrawal from a joint-venture in Brazil.

For the moment it looks as though most multinationals stand by their investment in developing countries. But a sustained reduction in FDI flows could have repercussions for countries that have become over-dependent on capital inflows to finance their current account imbalances.

For example Brazil, like many other countries including the US, has used high levels of FDI inflows in the past few years to finance its current account deficit. At the start of the year the Brazilian central bank was predicting FDI inflows of $24bn, more than enough to cover the projected 2001 deficit of $23.7bn. However, at the beginning of October, Ilan Goldfajn, Brazil’s central bank director of economic research, forecast FDI inflows for 2001 of just $19bn. If FDI flows deteriorate again in 2002, economic imbalances like this will become even harder to sustain.

FDI lifeline

Fortunately for emerging markets, foreign direct investment flows are likely to be the most stable form of financial flows. Although FDI flows to developing countries are expected to fall this year, it is expected to be only a modest 6% from $240bn in 2000 to $225bn this year according to the recent figures from UNCTAD.

In contrast, the Institute of International Finance (IIF) predicts flows of portfolio investment into emerging markets will fall from $16.3bn last year to just $3.8bn in 2001, a staggering crash of 77%. Meanwhile, inflows of capital to emerging markets in the form of bonds and loans of $20.3bn in 2000 are expected to turn into net outflows of $22.1bn in 2001. In this context, FDI flows begin to look like an economic lifeline to emerging markets.

IIF director of research Kevin Barnes says longer-term investments are less likely to be jeopardised by the economic and political situation than short-term investments: “Already investors are showing clear short-term risk aversion. What is not clear is how strong and how lasting this will be.”