There is heavy coverage in the financial press about the increasing level of government debt in advanced countries and the impact this has on their sovereign bond rates.

However, the potential impact of such rising levels of debt on countries’ ability to attract FDI and the potential for FDI to help overcome this crisis have not been discussed explicitly.

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The current increased level of government debt in developed countries is mainly a result of their effort to tackle the global economy’s deep recession. Although capitalism has been proved to be the most realistic and efficient system of allocation of productive resources in history, it is characterised by inherent instability that is amplified during times of crisis. In the past two years, a major private sector level crisis was transferred via increased government spending (including huge bailouts at times) to the state level.

The need to finance budget deficits threatens even highly advanced countries, such as the UK, to approach a government debt level incompatible with an AAA rating, according to Moody’s. Credit rating agencies do not evaluate the ability of a country to serve its debt according to its past performance, but via predicted future performance.

According to a report by the US-based National Center for Policy Analysis, advanced economies are characterised by high fiscal imbalances. These are the additional resources a government must have on hand today, invested and earning interest, in order to continue current policies (such as pensions) in the future.

According to this report an average EU country, in addition to projected taxes and other revenues, would need to have 434% of its current annual GDP in the bank, earning interest at the government’s borrowing rate, in order to fund current policies infinitely. Although the report does not take into account factors such as technology shocks (that could increase productivity dramatically) or alteration in government policies, it provides evidence that the debt dynamics of the advanced economies are currently negative. This, in combination with anaemic and uncertain future growth projections, puts additional pressure on sovereign bond rates with the danger of entering a vicious circle of government debt. These unfavourable conditions in most industrialised countries are making the need to reduce debt levels, while increasing growth dynamics, imperative.

 

The link to FDI

How do these realities link to the FDI attractiveness of advanced countries? Although FDI is a firm-level decision, the criteria for the destination outcome of such decisions are set at the country level. The literature related to the FDI determinants identifies two main types of strategic motives for FDI relevant to advanced countries:

  • Market seeking: Access to local or regional markets.
  • Knowledge seeking: Access to advanced technological and human capital assets. This is the most advanced form of FDI, as it aims to tap into the innovation systems of other countries.

For both these strategic motives, the expected changes in the relative FDI attractiveness of the advanced countries will happen mostly in the long term. As far as the market-seeking motive is concerned, industrialised countries still represent the major global markets, although their relative significance is slowly declining compared with the emerging markets.

Related to the knowledge- seeking motive, advanced countries are at the forefront of innovation and although some emerging markets are catching up in terms of technology, they still represent just a fraction of the global technological output (see table below).

In the short term then, even measures such increased taxation are not expected to have a major impact on the relative FDI attractiveness of the advanced countries. Even if a potential increase in taxation lessened the attractiveness of a country as an FDI destination, this decrease would be relatively small, as advanced markets are too large to ignore in terms of market weight and stand at the technological forefront.

In fact, deep economic changes are a long-term process. The ability of industrialised countries to remain the most competitive economies in the world, and so the most attractive FDI destinations, will depend on how they constrain their debt dynamics while increasing their growth potential.

This is a very hard task as limitations in government spending could negatively affect essential long-term determinants of both growth and FDI in advanced countries. The innovation capacity of a country (R&D spending), its infrastructure and the quality of its human capital are just some examples of essential determinants both for FDI attractiveness and competitiveness that could deteriorate because of budget restraints.

 

FDI as a catalyst

For advanced countries, then, reducing government debt via mere limitations in public spending will not be sufficient. Such an effort needs to be co-ordinated with the following:

  • The continuous strengthening of the key growth and competitiveness determinants of each country.
  • The transfer of relatively reduced financial resources from low growth sectors of the economy to sectors with high growth potential.

Although FDI cannot be regarded as the major driver for growth, it offers significant potential as a catalyst in the economic restructuring effort.

The recent increase of FDI from emerging economies such as China could accelerate the process of rearranging the economic structure of the advanced economies towards innovation-driven sectors. When an industry is characterised by low profit margins and the competition is based on cost control, companies from emerging economies have a competitive advantage over companies from advanced economies. Take the example of Lenovo’s acquisition of the PC segment of IBM. Although competition in many PC components is still innovation-driven, the actual assembling part of the industry is characterised by falling profit margins and cost considerations. Such a move enabled IBM to focus on its innovation-driven segments while, at the same time, its PC segment became more competitive under Lenovo.

FDI between developed economies has important potential for growth, especially in emerging industries such as renewable energy. This is because the trajectory of the development of such industries stands at different levels even between these countries. Greece, for example, has a favourable weather conditions for such projects. However, the sector is underdeveloped because of the relatively low technological capacity of the country. Greece is in financial distress and so has limited ability to channel funds for the creation of a competitive renewable energy industry. FDI from countries such as Germany or Spain, that already possess world-class renewable energy clusters, could benefit Greece in diversifying its distressed economy towards this high-growth sector, while the industries of the source countries would benefit too.

The usefulness of FDI as a catalyst for economic restructuring will also depend on each advanced country’s institutional capacity. Cuts in government spending must be well co-ordinated with the wider economic development efforts and the increase of each country’s FDI attractiveness. Budget cuts should be geared primarily towards the cost of running the state (ie, bureaucracy) and the less productive sectors of the economy, rather than towards measures that could reduce the scientific base or lead to the deterioration of essential infrastructure of each country. Even in the case of potential tax increases, these could be accompanied by tax breaks in R&D and innovation expenditure.

Investment promotion agencies (IPAs) could become important vehicles to carry out the FDI part of this effort. It is important to recognise and target the opportunities that companies from emerging markets offer in terms of inward FDI, especially in the relatively low-tech sectors of the economy. Additionally, the coordination of IPAs in developed countries could be helpful in identifying similarities between their economies that could be exploited via FDI – resulting in benefits for both the home and host countries.

 

Antonios N Kalyvas is a PhD researcher (FDI) at the Centre for Finance & Risk, Bournemouth University.