Simon Evenett is an economics professor, and Camilla Erencin a PhD candidate in economics, at the University of St Gallen, Switzerland. Felix Reitz is a strategy consultant at McKinsey.

Investors are at sixes and sevens over the future path of interest rates. While some reckon a doveish US Federal Reserve will cut rates this year absent a crisis, the likelihood of a return to the era of cheap money is slim. FDI won’t escape the consequences of higher corporate costs of capital, a factor that might drag on the propensity of internationally active companies to establish greenfield projects and engage in cross-border mergers and acquisitions. Ultimately, however, it’s the implications for state policy to attract FDI that interest us here.

Let’s ground the discussion in pertinent facts. We’ve tracked the financial performance of some 40,000 publicly-listed firms since 2005 as part of the Crux of Capitalism initiative. These firms are located in 21 economies, which together accounted for more than 84% of global FDI flows from 2018 to 2022. We’ve calculated the median weighted average cost of capital (WACC) of the biggest 25% of firms in each of these countries measured by asset size. 

Our data shows how the median WACC of the largest firms in China, Germany, Japan and the US has varied since the start of 2019. Although the turning point from falling to rising WACC varies, by the second quarter of 2022 the median WACC was rising in all four economic behemoths. Since their nadirs, the median WACC has risen more than 300 basis points in each of these big four economies. The repricing of capital is occurring in all sectors that we’ve tracked. From industrials and healthcare to IT and consumer goods, no sector is immune, it seems.

Calling new tactics to lure FDI

The many advantages of FDI for recipient economies aren’t affected by the repricing of capital, so we can confidently expect that governments will keep trying to lure projects from foreign firms. How they go about this is likely to change, however. Greater costs of capital will raise hurdle rates for FDI. Governments and investment agencies will come under pressure to offer larger financial sweeteners, including tax breaks. States may even be willing to partially finance FDI, taking stakes in what effectively could become public-private partnerships. Indeed, expect much more talk about collaboration and joint deployment of local and foreign capital. 

However, not every government has deep pockets. This isn’t just a concern for lower per-capita income emerging markets. After racking up significant public sector debts during the Covid-19 pandemic, some industrialised countries have very little fiscal space. In these economies, governments will come under pressure to revisit their strategies for attracting FDI, not least from hard-nosed finance ministries. 

Fortunately, there are plenty of public policy tools beyond fiscal inducements that affect companies’ desire to invest via FDI. For example, in many countries the level of regulatory and business-relevant public policy uncertainty remains well above the norm and has plenty of room to fall. Regulatory processes should be reviewed to afford foreign investors greater predictability, which in turn lowers risk premia. It is time to revisit the regulatory overdrive of recent years. This is not a sweeping argument for deregulation, rather an argument for more deliberate, stable regulatory structures.

Governments with limited fiscal space should take the opportunity to revisit the range of regulations and taxes on businesses that affect incentives to invest. Many of these reforms don’t involve large fiscal outlays and may also induce domestic firms to invest, an additional pay-off. In short, the repricing of capital could shift policy dynamism away from the fear-driven regulatory initiatives of recent years (for example, attempts to create ‘resilient’ supply chains after temporary pandemic-era shortages) towards easing the heavy burdens on business. A byproduct of the normalisation of monetary policy and fiscal space constraints is that greater differentiation in how states chase FDI can be expected. 

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