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Megacities and well-known country capitals have been perennial favourites for FDI. However, astute investors are increasingly looking beyond the obvious, as Sebastian Shehadi discovers.

The march of urbanisation now has one in two people in the world living in cities, producing 80% of global GDP, according to a McKinsey report. Of that figure, a whopping 60% is generated by 600 leading cities that house one-fifth of the world’s population, while the following 400 cities contribute just 6%.

At the top of the 600 leaders are megacities such as Tokyo, Mumbai, Beijing, New York and London, which account for 10% of global GDP. The rest of the top 600 are tier-two cities, also known as ‘middleweights’ and defined as having 150,000 to 10 million inhabitants.

Tier-two cities are driving global growth by generating roughly 50% of global GDP, according to McKinsey. The leading middleweights are mostly capital cities or regional economic hubs, such as Manchester in the UK and Cologne in Germany, and McKinsey says they are poised to outperform most megacities in their absolute level of growth, based on three criteria: demographics, households and incomes.

In China, 166 million people are expected to urbanise over the next 14 years, 75% of them heading towards lower tier cities, according to Robin Xing, chief China economist at Morgan Stanley. Already, Chinese middleweights comprise 59% of the country’s GDP and 73% of its population, he adds. Opportunities abound for foreign investors that can identify attractive middleweights.

Size not everything

Out of about 4500 cities in the world, the 42 megacities have garnered 11% of total greenfield FDI flows since 2003, according to fDi Markets. Indeed, most megacities are economic giants with vast markets, pools of top talent, standardised services and all the other benefits of mass economic agglomeration.

However, economies of scale often regress into diseconomies of scale, thereby causing megacities to experience slower growth in their per capita GDP, according to Richard Dobbs, senior partner at McKinsey.

“Many city governments are not prepared to cope with the speed at which their populations are growing. Without skilful planning and management, cities run the risk of diseconomies, such as congestion and pollution, starting to outweigh scale benefits, leading to a deteriorating quality of life and a loss of economic dynamism,” he adds.

Mega issues

Megacities in the developing world have the most extreme diseconomies. For example, Delhi, Cairo and Bangkok are among the most congested and polluted cities in the world. Deficient infrastructure and transport, lack of housing and sharp disparities of wealth have created megaslums and residential overpricing.

Meanwhile, megacities in developed countries also suffer from extremely high housing prices and injurious levels of congestion and pollution.

Like many sectors over the past decade, the real estate market in Europe’s largest cities is overcrowded, thereby making prices soar. This turns investor eyes to middleweights. Christian Müller, a partner at Thommessen real estate law firm, says: “With the London, Paris and central European market too busy, international private equity funds are widening their scope and [looking] to [fresher] markets, such as Oslo.”

The largest tier-two cities often share similar problems to megacities, which is why small to medium-sized middleweights (with a population below 5 million) are becoming increasingly attractive to people and investors, and are set to grow the fastest, according to McKinsey’s report.

Fast-growing middleweights are somewhat threatened by their own success, which is why Alain Juppé, mayor of Bordeaux, told fDi: “I would like to reconcile the growth of the city and the quality of life. We’re a city but in the countryside. I don’t want to be Tokyo – [it’s] important to maintain this attractiveness.”

Shifting sands

Many middleweight cities offer refreshing alternatives in terms of quality of life. Although a generalisation, they tend to provide a lower cost of living, the ability to walk or cycle to work, and greener, safer, less polluted spaces that have a strong ‘sense of community’.

Like many other tier-two cities, the deputy mayor of Poland’s Gdynia, Katarzyna Gruszecka Spychała, draws on these strengths to attract talent and FDI. “Our brand is a high quality of life. The cost of living and doing business is lower here. We listen carefully [to inhabitants’] needs and ideas,” she says. “[Similarly], Gdynia builds individual, [long-lasting] relationships with each investor and provides bespoke support.”

An increasing number of people, and therefore talent and investment, are being drawn to these attractions. This partly explains why megacities and the largest middleweights are seeing slower population growth and an uptick in domestic out-migration, according to a recent Brookings Institute analysis of US census data.

Some of western Europe’s very largest cities exhibit similar trends. London lost a net 305,000 inhabitants, mostly young families, between 2011 and 2016. Indeed, the net departures for London over the past five years have increased by more than 80%, according to real estate firm Savills, not least because the average house price in the UK is £250,000 ($330,000) cheaper outside London.

Home ownership among young British people has halved within 20 years, according to a recent study from the UK's Institute for Fiscal Studies. The enormous rise of student loans in the UK since 2012 is expected to exacerbate this trend. Heavy personal debt and housing prices are having a similar effect on millennials in the US.

A potential consequence of this trend is a growing youth culture against materialism. Indeed, a study by Harris Group found that 72% of millennials prefer to spend money on experiences than on material things, not least because lifestyle and health are becoming ever more important.

This does not mean that millennials are not career driven, but that they are less likely to sacrifice a balanced lifestyle for more money. Leading tier-two cities can provide millennials with both.

Strategy for success

Thanks to visionary local leadership, some of the most successful tier-two cities in Europe have reinvented themselves into world-class specialists. Pittsburgh (the US), Edmonton (Canada), Malmo (Sweden) and Sheffield and Manchester (the UK) are good examples: previously heavy industries turned knowledge-based economies with well-regarded universities and thriving specialisations.

Edmonton is a global leader in artificial intelligence, machine learning and aerospace, while Sheffield is recognised for its creative media, advanced manufacturing, and health and wellbeing. Malmo has flourishing tech start-ups, green initiatives and a youthful population – all of which are hallmarks of successful small to medium-sized middleweights.

Indeed, Madison (Wisconsin) and Indianapolis (Indiana) have thriving tech scenes, including headquarters for large companies (respectively, Epic and Salesforce). This trend is supported by the changing nature of work – the ‘gig’ economy, remote work, bedroom start-ups – thereby providing alternatives to conventional city office life. The picture in India is similar: Jaipur, Ahmedabad, Pune, Chennai and Vizag are rapidly becoming specialised hubs for the growth of key industries such as fintech, software as a service, agritech and deep tech.

Decentralisation benefits

Regional and national connectivity also appears to be essential for successful middleweights. However, the well-connected and internationally minded cities tend to attract the biggest multinational corporations – which is why many leading middleweights emphasise their internationalism, an example of which is Brisbane’s marketing slogan, ‘Australia’s new world city’.

Governance structures are also important. “Germany’s federal organisation makes its regional capitals far more important than the second-tier cities [in Europe], especially in more centralised countries such as [in eastern Europe], but also the UK,” says Rosemary Feenan, director of global research at JLL.

Germany’s experience suggests that decentralisation creates stronger tier-two cities that in turn drive strong national economic performance. Most national governments across Europe disproportionately fund and develop their capital cities while neglecting their secondary cities, especially since the 2008 financial crisis, according to the European Institute for Urban Affairs at Liverpool John Moores University.

For smaller tier-two cities, the impact of government centralisation is even more acute – one reason why Jon Collins, leader of Nottingham City Council in the UK, says the challenge for a city such as his is in “driving spec-investment”. This is partly because Nottingham does not have the commercial yields or land values of London and needs more investment to create those higher yields, creating something of a vicious cycle.

For this reason, Manchester City Council leader Sir Richard Leese says the greatest economic opportunity for Manchester is the “progress [the UK has] made with devolution and decentralisation”.

Strength in numbers

To counter some of the FDI challenges faced by tier-two cities, namely lack of international recognition, Edmonton and Sheffield have established a tier-two cities network. The stated aim, according to Faaiza Ramji, the principal at business marketing firm OnPurpose, is “to help connect cities based on true symbiotic opportunity, not because of arbitrary desire for alignment”.

“By identifying cities, connecting people and exploring opportunities and challenges, we can take a lean, iterative approach to building trade partnerships and identifying investment opportunities,” she adds.

Smaller middleweights cannot wait for FDI to find them, but must reach out to investors. As with very small countries, “micro targeting” is important for middleweights, according to Chris Cardona, Malta’s minister for economy, investment and small business.

“Individualise potential countries, regions and potential investors in those areas which are profitable," he advises. "Do the groundwork for potential investors and come up with their business plans, so to speak.” 

This article is sourced from fDi Magazine
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