Attracting foreign direct investment (FDI) for nearshoring will play a key role in Latin America and the Caribbean’s economic recovery and sustainable growthafterthe COVID-19 crisis.
However, countries in the region need to design targeted investment attraction strategies if they are to attractproductionactivities currently based in other areas of the world, such as Asia. This is one of the conclusionsreachedin a newIDBstudy,Foreign Direct Investment: Definitions, Determining Factors, Impacts, and Public Policies, which seeks to explainthe nature and dynamics of FDI and to identify the factors that determine it and its potential impact on host countries.
FDI is a transaction involving a long-term relationship in which an individual or a legal entitythatis resident in one economy (a direct investor) seeks to obtainan abidinginterest in and significant influence over an enterprise that is resident in another economy. This contrasts with portfolio investment, which tends to be short-term and does notentailany intention of control on the part of the investor. Companies that engage in FDI are usually referred to as transnational corporations (TNCs) or multinational corporations (MNCs).
What motivates Foreign Direct Investment
Understanding why companies decide to expand their operations and set up in a third country and what the deciding factors are when it comes to choosing a new location are both keysfor host countries designing investment attraction policies, for which they receive support fromInvestmentPromotionAgencies.
There are four types of FDI:natural resource-seeking,market-seeking,efficiency-seeking,andstrategic asset-seeking. Each of these types responds to different host-country localization advantages, although there are also broader-reaching determining factors such as the regulatory and macroeconomic environments of destination markets.
RESOURCE-SEEKING INVESTMENTS:these aim toexploitnatural resources, the availability of which is the main location advantage offered by the host country. In the past, these kinds of investmentsoften createdenclaves within host countries, generating reduced linkages and spillovers for its economy. This is no longer necessarily the case now that technology and specialized services are increasingly being incorporated into primary activities.
MARKET-SEEKING INVESTMENTS:these aim to leverage the domestic market of the host country (and, eventually, that of other nearby countries). Some of the factors that influence this type of FDI include the target market’s size and growth rate,the aim of buildinga presence in major markets or followingclients and/or suppliers engaging in FDI operations, the existence of physical barriers and/or high transportation costs, the need to adapt goods and services to local tastes and requirements, and the host country’s public policies.
EFFICIENCY-SEEKING INVESTMENTS:these seek to rationalizethe multinationals’production tomake the most ofeconomies of specialization and scope while diversifying risk. MNCs pursuing such strategies take advantage of differences in factor endowments, localcapabilities, public policies, demand patterns, and cultural norms to concentrate differentproductionlines inotherlocations.
These strategies are favored byliberalizationand integration processes, reductions in transportation costs, and advances in information and communication technologies (ICTs). They frequently emerge as a result of complementation and articulation schemes for both commercial and production-related operations within the MNCs’different subsidiaries. These strategies are closely linked to the dynamics of global value chains (GVCs).
STRATEGIC ASSET-SEEKING INVESTMENTS:the main objective is to acquire resources and capacities that allow the investmentfirm to maintain or increase its global or regional competitiveness. The strategic assets sought bymultinationalsmay range from innovation capacities andorganizationalstructures to distribution channels or better understandings of consumers’ needsin new markets. Mergers and acquisitions are often associated with this type of strategy.
Finally, recent empirical research suggests that considerable diversityexistsin MNCs’strategies: internationalization processes are influenced by firm type, sector and markets, trade activities, FDI, outsourcing, and strategic partnerships. For many firms, investments to increase capacities, complementary assets, and/or productive diversification (conglomerate FDI) play an increasingly important role within their portfolios.
The macroeconomicand microeconomic impacts ofForeign Direct Investment
The impacts of FDI can be divided into two categories: the macroeconomic and the microeconomic.
When it comes tomacroeconomicimpacts, FDI represents a flow of foreign currency that provides a source of financing that is theoretically less volatile than that of other channels, such as portfolio investment. FDI can also lead to a direct increase in the host economy’s capital stock in greenfieldinvestments or capacity expansions. In the latter case, FDI can be expected to impact economic growth and job creationpositively.
From themicroeconomicperspective, FDI can generate a set of positive externalities associated with transfersof knowledge and know-how between investor firms and recipient firms. Productivity gains for host economies occur through direct technology transfers, the spread of technological and organizational best practices, and employee mobility, among other channels. FDI can also contribute to increasing and diversifying exports and transforming the productive structure of the countries where the subsidiaries are located.
However, empirical evidence shows that positive impacts like these are far from automatic. Indeed, there are even cases of negative productivity spillovers for local firms (e.g., firms competing in the same market).
Therefore, thesign and magnitude of the impact of FDI depend on a set of circumstances that have to do with factors that are specific to host economies. For example,human capital levels, local firms’skills and capabilities, infrastructure, the depth of the financial system, andthe type of FDI in question and the motivations behind it.In this sense, attracting investment in high value-added sectors that demand highly skilled human resources (such as the automotive andaerospace industries) isa very different undertaking toattracting investment in extractive sectors with limited local linkages.
FDI, vitalforLatin America and the Caribbean’s post-pandemic future
FDI will play a decisive role inLAC’sgrowth and development after the COVID-19 pandemic, especially if there is a widespreadnearshoring ofGVCs. Thissupply chain realignmentcalls for a rethinking of both the forms and objectives of investment promotion policies in a context of intense competition to attract and retain global investment.
Although,in historical terms,the weight of FDI as measured against global GDP remains high, international investment flows have slowed in recent years (the ratio of FDI flows to GDP fell from 2.3% in 2000 to2%between 2010 and 2018). This has happenedin tandem with the slowed growthofglobalization brought on by the global systemic crisis. The COVID-19 crisis is likely to reinforce this trend, given theprotectionist pressure and trade tensionsbetween the major global economies andamove towardreshoringandnearshoring,makingvalue chains more regional than global.
Latin America and the Caribbeanhas maintained a relatively high and stable share of global FDI flows,averaging between 8% and 9% in recent five-year periods. However, exceptforMexico, its role inGVCshas been limited and is usually far from the most complex stages in these chains.
The post-COVID-19 scenario is an opportunity for the region to reverse these trends by designing targeted investment attraction strategies that seek to attract FDI associated with thenearshoringof activitiesthat arecurrentlybasedin otherpartsof the world.
One lesson that emerges after analyzing other successful experiences is that FDI promotion policies should be complemented by instrumentsthat seekto improve local capabilities and assets and stimulate direct linkages between MNCs and domestic enterprises. This is the challenge facing Latin America and the Caribbean in the coming years.