Fdi Inflows in Developed and Developing Countries

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Foreign Direct Investment (FDI) is when a company or an individual invests in another business in another country, by either obtaining the business assets e.g. ownership of the company or creating business operations. For example, due to the low cost labour or the natural resources, European and U.S firms have invested in China, India and Russia. The patterns of FDI inflows in developed and developing economies have been changing and this is due to forces that bring change in the FDI inflow pattern. In this essay I will explaining these forces in which brought the changing patterns in FDI inflow using the most suited international trade theory and why the chosen theory is the most appropriate theory to explain the changing patterns of FDI inflow in developed and developing countries.

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The graph above shows the growth of the dollar volume of Foreign Direct Investment since the 1980s especially in advanced economies like Japan, Europe and North America. As can be seen the pattern of FDI inflows have been changing. From 1980-1984 there seems to be a steady growth in FDI inflows into developed countries, developing countries and the world. The suggested conclusion is that “globalization” did not show any general upward trend before the late 1980s, therefore FDI had a steady growth. However in 1985, there was a surge in FDI inflows. There are two main explanations have been suggested for these surges in FDI:

• Exchange rate fluctuation: This is as exchange rates differentially affect the amount of money that international businesses pay in for assets, or affect a firm’s ability to buy assets abroad with available cash. Therefore this can lead to surges in FDI. An example of a shock that could have caused a surge In FDI inflows happened in the United States. In 1986 the U.S there was a rush of FDI inflows as there was a period of dollar weakness. A weak dollar may make the U.S assets seem more attractive, it should do so for both foreign and domestic firms. However, in principle, it should not encourage foreign direct investment if firms are cash constrained. However, a fall in the dollar means that yen and pounds go further in buying U.S. assets; the fall thus encourages a wave of inward investment.

• Changes in taxation: Scholes and Wolfson provided a theory and argued that changes in the U.S tax law have an effect on the level of Foreign Direct Investment in the US. The evidence they gave for this was that there was a decrease in investment after the 1981 Economic Recovery Tax Act however when the Tax Reform Act was introduced there was an increase in FDI inflows in the U.S. This could be a reason as to why there was surge in 1985 in FDI inflows.

To summarise, it is quite difficult to explain why there was a sudden surge in FDI inflows during 1986. This is as it is a theoretical problem. Before 1985, globalisation was not as popular therefore explaining trends before globalisation but explaining trends towards globalisation is easier.

In the years 2000-2001, FDI flows into and out of countries part of the OECD (which is the Organisation for Economic Co-operation and Development of 34 countries, founded in 1961 to stimulate economic progress and world trade.) recorded their largest drop in decades which had a decline of around 56%. According to the United Nations Conference on Trade and Development(UNCTAD) report, in 2001 the decline in FDI inflows in developed countries decreased by 59% compared to developing countries which only declined by 14%. This was due to the FDI inflows being interrupted, especially in 2001 as investors began to panic due to the terrorist attacks in 11th of September 2001 in the United States (who are part of the OECD countries). This massively affected trade and investment as investors were not confident in investing in the countries. Another reason would be the fact that the worlds three largest economies all fell into a recession; this affected FDI inflows because firms did not want to invest in countries with weak economies as the firm will struggle and not succeed as they will in stronger economies. The drop in FDI inflows affected countries differently for example the largest drops in FDI inflows were in Germany and Belgium. The United States and United Kingdom were both in line OECD averages however that changed between 2000-2001 when their FDI inflows dropped to below average. However, France, Greece and Italy did not fall into the general trend of decline in FDI inflows and actually increased in FDI inflows in 2001.  

Again in the chart, in in the years 2008-2009 it shows another decline in FDI flows in the developing, developed and the world.  During 2008 the credit crunch and recession was caught up to developing markets meaning that their outflows and inflows of FDI started to decline ( fell by 16% in 2008), therefore this meant that in 2009 there was an FDI recession which became global. This meant that there was a decline in Greenfield investments (which mean according to Investopedia a form of foreign direct investment where a parent company builds its operations in a foreign country from the ground up) which dropped 15% from 2008 to 2009 in developing countries. Greenfield investments are vital in developing countries than developed countries. This is as developing countries need new business in order to help the economy grow.  This is how it affected developing countries. However it affected developed countries in a different way. The global recession steered to liquidity restrictions for transnational corporations (TNCs) worldwide as the access to credit got harder which means that even though they wanted to, the capability for a business/country to invest would have weakened. Furthermore the link between economic growth and FDI meant that because of the recession, the FDI inflows became interrupted and slowed down, especially for the developed world. This is as TNCs were not really confident in investing abroad and they ignored high-risk projects like major infrastructure. This meant that FDI inflows in developed, developing and even the world had a major decline. Looking at the chart the FDI inflows in developed countries declined more harshly than developing countries, this is as the crisis started in western countries. For example according to the national statistics flows of direct investment abroad by UK companies (Outward Investment) fell to £85.8 billion in 2008. This represents a decrease of £73.4 billion on the amount invested in 2007. This decline really affected Western banks and financial institutions, which meant that they had to cancel, postpone, cross-border mergers and acquisitions (M&As) – the most important manner for FDI.