5. Key Concepts in the Measurement of FDI
- Neil Patterson, Marie Montanjees, Colleen Cardillo, and John Motala
- Published Date:
- September 2004
5.1 As introduced in Chapter 2, the BPM5 defines direct investment as a category of international investment that reflects the objective of a resident in one economy (the direct investor) obtaining a lasting interest in an enterprise resident in another economy (the direct investment enterprise). The lasting interest implies the existence of a long-term relationship between the direct investor and the direct investment enterprise and a significant degree of influence by the investor on the management of the enterprise.
5.2 The concept of direct investment does not necessarily imply control of the direct investment enterprise because, according to BPM5, an ownership criterion of only 10 percent of the ordinary or voting shares of the direct investment enterprise is used to define or establish a direct investment relationship. In practice, however, a large proportion of FDI capital involves majority-owned subsidiaries and branches. For example, Statistics Canada reported that majority-owned subsidiaries and branches accounted for 93 percent of Canada’s stock of inward FDI and 94 percent of the stock of outward FDI in 2001. The Godeaux Report found similar ratios for several industrial countries—94–96 percent of inward FDI and 83–97 percent of outward FDI was accounted for by majority-owned subsidiaries and branches. The Godeaux Report also noted that “equity holdings in the range of 10 to 20 or 25 percent accounted for only 1 or 2 percent of the stock of direct investment.”
5.3 The lasting interest in a direct investment enterprise typically involves the establishment of manufacturing facilities, bank premises, warehouses, and other permanent or long-term organizations abroad, but it may also involve the operation of mobile equipment such as drilling rigs and construction activities, and expenditure on exploration for natural resources. This may involve the creation of a new establishment abroad (“greenfield investments”), joint ventures, or the acquisition of an existing enterprise abroad (M&A). The direct investment enterprises can be incorporated or unincorporated and can include ownership of land and buildings by nonresident enterprises, as well as by nonresident individuals.
5.4 Once a direct investment relationship has been established, all subsequent capital transactions between the direct investor and the direct investment enterprise and among affiliated enterprises resident in different economies are considered to be direct investment. The direct investment relationship extends to certain other enterprises indirectly owned by the direct investor. Thus, direct investment enterprises comprise nonresident subsidiaries, associates, and branches either directly or indirectly owned by the direct investor. The inclusion of transactions with and between indirectly owned entities can greatly extend the number of entities involved in the direct investment relationship, and adds to the complexity of compiling the data.
5.5 Once established, increases in FDI can take the form of injections of additional equity capital, the reinvestment of earnings not distributed as dividends by subsidiaries and affiliated enterprises and earnings of branches not distributed, and intercompany debt, both long- and short-term, such as the extension of suppliers’ credits or loans, all of which represent FDI capital.
5.6 FDI capital flows are recorded on a net basis, in the same manner as other cross-border financial flows (that is, investments during the reporting period are netted against disinvestments, separately for claims and liabilities). FDI is recorded on a directional basis—broadly, as an asset for the economy of the direct investor and as a liability for the economy of the direct investment enterprise.
5.7 Two recording features—that of recording transactions with indirectly owned direct investment enterprises (for example, transactions between two foreign subsidiaries of the direct investor located in different economies) and the netting of certain transactions between the direct investor and the direct investment enterprise (reverse investment)—appear to pose special difficulties for compilation and contribute to asymmetries in the recording of FDI.1 These two items are discussed in Box 5.1. Other selected recording features of FDI transactions, stocks, and investment income are described in the following paragraphs. Some of these features—such as the valuation of direct investment stocks and applying the Current Operating Performance Concept to measure direct investment earnings—also pose difficulties for compilation.
Box 5.1. Treatment of Indirectly Owned Enterprises and Reverse Investment
Indirectly owned direct investment enterprises
Once a direct investment relationship has been established, all subsequent capital transactions between the direct investor and the direct investment enterprise and among affiliated enterprises resident in different economies are considered to be direct investment. In other words, the direct investment relationship extends to certain other enterprises indirectly owned by the direct investor. Thus, the direct investment enterprises comprise: (i) subsidiaries (enterprises in which the investor owns more than 50 percent); (ii) associates (enterprises in which the investor owns 10–50 percent); and (iii) branches (wholly or jointly owned unincorporated enterprises) either directly or indirectly owned by the direct investor. In the OECD’s Benchmark Definition (OECD, 1996) the treatment of indirectly owned direct investment enterprises is referred to as the “Fully Consolidated System.” Countries have reported difficulties in obtaining the level of detail needed to track the chain of ownership of indirectly owned enterprises, particularly for multinational corporations that have a large global base. Only 11 of the 61 countries surveyed in the 2001 SIMSDI update fully applied the Fully Consolidated System for their inward FDI transactions.
Reverse investment occurs when a direct investment enterprise acquires a financial claim on its direct investor. Because direct investment is recorded on a directional basis, capital invested by the direct investment enterprise in its direct investor is regarded as an offset to capital invested in a direct investment enterprise by its direct investor or its related enterprises, except in instances when the equity participations are at least 10 percent in both directions. For example, if the direct investment enterprise acquires equity in its direct investor that represents less than 10 percent of the total equity of the direct investor, that investment would be recorded under FDI in the reporting economy in line with the directional basis for recording direct investment (see classification below). In effect, the equity investment is regarded as an offset to the capital invested by the direct investor (that is, as disinvestment). Similarly, a reduction in inward FDI would be recorded if the direct investment enterprise makes a loan to the direct investor. However, in cases where the equity participation by the direct investment enterprise in its direct investor reaches or exceeds 10 percent of the total equity of the direct investor, the IMF’s BPM5 recommends that two direct investment relationships be established; that is, the investment by the direct investment enterprise in its direct investor or related enterprise is regarded as the establishment of a direct investment abroad.
|Abroad||In Reporting Economy|
|Equity capital||Equity capital|
|Claims on affiliated enterprises||Claims on direct investors1|
|Liabilities to affiliated enterprises1||Liabilities to direct investors|
|Reinvested earnings||Reinvested earnings|
|Other capital||Other capital|
|Claims on affiliated enterprises||Claims on direct investors1|
|Liabilities to affiliated enterprises1, 2||Liabilities to direct investors2|
FDI Capital Flows
5.8 Equity capital covers equity in branches; voting or nonvoting shares in subsidiaries (greater than 50 percent ownership) and associates (10–50 percent ownership); and other capital contributions, which can include the provision of machinery or other capital equipment, raw materials, and technical know-how.
5.9 A direct investor can also increase its direct investment equity through the reinvestment of earnings of the direct investment enterprise, which consist of the direct investors’ share (in proportion to equity held) of earnings not distributed as dividends by subsidiaries or associates and earnings of branches not remitted to the direct investor during the reporting period. In conformity with the double-entry system for constructing the balance of payments, the BPM5 recommends, for the economy of the direct investor, the recording of a credit in rein-vested earnings under FDI investment income for the amount of the reinvested or undistributed earnings of the direct investment enterprise abroad, together with an offsetting debit entry under FDI abroad to reflect the net increase in investment arising from the undistributed earnings.2 The rationale for this “imputation” is that the direct investor has consciously chosen to forgo a distribution of income and elected to increase its investment in the direct investment enterprise.
5.10 Like other financial transactions, undistributed earnings are recorded on a net basis—earnings from operations are netted against any operational losses incurred during the reporting period. Earnings should be measured net of host-country income and corporation taxes and depreciation, and exclude realized and unrealized capital gains and losses, write-offs, and realized and unrealized exchange rate gains and losses: that is, conform with the Current Operating Performance Concept of recording direct investment earnings. If operating losses exceed profits, the recommended recording remains the same as above, except that a net debit would be recorded in reinvested earnings under direct investment income in the current account, and a credit would be recorded under FDI abroad to reflect the net decrease in investment arising from the losses. At times, this recording practice can give rise to peculiar results in the current account, such as negative investment income receivable, whenever unusually large losses are incurred by direct investment enterprises abroad. (Conversely, the economy of the direct investment enterprise would record a credit under investment income payable.)
5.11 The international statistical methodology also recommends that the reinvested earnings of indirectly owned direct investment enterprises (see Box 5.1) be included in proportion to the indirect ownership of the equity of those enterprises, which may be difficult to measure when they extend down through a chain of affiliates. The ability of compilers to gather the necessary data may also be constrained by accounting conventions regarding the preparation of consolidated company accounts.
5.12 The third component of FDI capital—other capital—covers intercompany debt—that is, the extension of trade credits, loans, and other advances to the direct investment enterprise. The BPM5 makes two important exceptions. Intercompany debt transactions between affiliated banks (depository institutions) and between affiliated financial intermediaries, including auxiliaries (for example, security dealers) recorded under FDI are limited to those transactions associated with permanent debt (loan capital representing a permanent interest) and equity (share capital) investment or, in the case of branches, fixed assets.3 Second, intercompany transactions in financial derivatives are not considered to be FDI.4
Cross-border mergers and acquisitions (M&A)
5.13 The surge in FDI flows during 1998–2000 was driven by cross-border M&A, which reached a record $1.1 trillion in 2000. Data on cross-border M&A transactions are published in UNCTAD’s World Investment Report and are based on information provided by Thomson Financial, a private commercial database. Although M&A data reported by commercial databases are widely used by the financial press and other users of business statistics, studies undertaken by the OECD and European Central Bank (ECB) indicate that these cannot be used as a source for FDI data, and should be used by national compilers only to check that all cross-border M&A transactions have been reviewed for possible inclusion in the FDI data. Data on inward M&A supplied by Dealogic, another commercial database, were published in 2002 in the OECD’s International Investment Perspectives, together with official country data on total FDI transactions. There were significant differences between the two sets of data, and in many cases the M&A transactions reported by the private commercial database were higher than the data on total inward FDI reported in the official balance of payments statistics.
5.14 Variations in the definitions of residence and the percentage ownership used to determine an FDI relationship account for some of the differences between the two sets of data. However, the most important difference appears to arise from the method used for recording the transaction, since the data in the private commercial databases include financing from domestic sources, or from unrelated foreign sources, that are not FDI transactions. In addition, in some cases the data include M&A between foreign affiliates and firms located in the same host economy.
5.15 The precise differences between the figures on cross-border M&A transactions recorded in the private commercial databases and the amounts that result in FDI cannot be accurately identified in many countries, since only a few OECD countries5 currently compile and disseminate FDI data showing “of which” lines for M&A.6 However, the official 2000 data for Canada for inward M&A transactions that resulted in FDI flows show a figure of $44 billion (Can$65 billion),7 which is significantly lower than the figure for total inward cross-border M&A of $139 billion (Can$207 billion) published in the OECD’s International Investment Perspectives.
Special purpose entities (SPEs)
5.16 It is useful to explain the treatment of SPEs, which the BPM5 recommends be included as FDI provided that they meet the criteria stated in the previous paragraphs. SPEs, which are frequently established in offshore financial centers, engage primarily in international transactions but have few or no local operations. Although SPEs may have different structures (for example, holding company, regional headquarters) or purposes (for example, administration, facilitation of financing), they are, according to the BPM5, an integral part of the structure of the direct investment network as are, for the most part, SPE transactions with other members of the direct investment group.
5.17 In recent years, the use of SPEs for “round tripping” has attracted attention in connection with the official data on FDI inflows to a number of Asian economies. The term “round tripping” refers to the practice of channeling local funds to SPEs abroad and the subsequent return of the funds to the local economy in the form of FDI capital. These transactions are motivated by tax and other incentives available to foreign investors. Although some analysts believe that this type of investment leads to an overstatement of the true magnitude of FDI, the recording of such transactions under FDI is in conformity with recommendations in the international statistical manuals. The funds channeled to the SPE (debit) would be recorded as outward FDI, and the return flow to the local economy (credit) would be regarded as inward FDI.
5.18 The classification of the stock of FDI assets and liabilities in the IIP is virtually identical to that shown for financial flows in Box 5.1. The only difference is that equity capital and reinvested earnings are combined into a single category in the IIP. The various factors that contribute to changes in the IIP are presented in Figure 5.1.
Figure 5.1.Factors Accounting for Change in the International Investment Position
5.19 In addition to the capital flows (including re-invested earnings) discussed above, other factors that contribute to increases/decreases in the stock of FDI in the IIP include:
Price changes—for example, changes in the market value of listed equity securities of direct investment enterprises; changes in the market value of holdings of land and buildings;
Exchange rate changes—for example, impact of valuation changes on foreign currency denominated loans from direct investors to direct investment enterprises (and reverse investment);
—Reclassifications—for example, a portfolio investor that owns, say,8 percent of the voting shares of an enterprise abroad increases the level of holdings to 10 percent. The previous 8 percent ownership would be reclassified from portfolio investment to direct investment in the IIP in the current reporting period (the additional 2 percent investment would be recorded as an FDI transaction in the balance of payments in the current period); another example would be where the direct investment enterprise acquires incrementally 10 percent or more of the voting shares of the direct investor. In this case, any equity holdings below the 10 percent threshold would be reclassified (when the 10 percent threshold is reached) from direct investment in the reporting economy (reverse investment) to direct investment abroad;
—Write-downs—for example, the direct investment enterprise is no longer a viable concern; natural resources owned by a mining enterprise have been fully depleted; exploration for natural resources proves unsuccessful, such as a “dry well.”
5.20 Trade credits, loans, and other advances from foreign direct investors also constitute a component of the external debt position in the economy of the direct investment enterprise.8 The same applies for reverse investment, where the direct investor borrows funds from the direct investment enterprise (see Box 5.1). In contrast to the portfolio and other investment components of the financial account, no distinction is made in the BPM5 standard components between short- and long-term investments within FDI capital, although some countries do compile such data.9 If the data are available to the compilers, the interagency External Debt Statistics: Guide for Compilers and Users, published by the IMF in mid-2003, recommends the dissemination of a short-/long-term maturity attribution of inter-company debt.
5.21 There are activities related to FDI that are not recorded in the balance of payments or IIP but that can subsequently increase (or decrease) the direct investor’s equity in the direct investment enterprise through an increase or decrease in reinvested earnings. For example, the operations of the direct investment enterprise can be financed through local currency borrowing in the domestic market by the direct investment enterprise, which would not be recorded in the balance of payments because it represents a transaction between two resident entities. These funds can be employed as working capital or to expand production, which could increase earnings that accrue to the direct investor (in proportion to equity held).
5.22 Direct investment enterprises can also expand operations in the local economy (or abroad) through M&A, which need not give rise to FDI transactions with the initial foreign direct investor or with other affiliates that are part of the “related group” if the transactions were financed locally or in international markets. Here, too, the direct investor’s equity in the direct investment enterprise can increase or decrease through reinvested earnings, as well as any revaluations that affect the books of the direct investment enterprise. For example, revaluations may result from capital gains and losses realized from the partial sale of a direct investment enterprise’s assets for an amount different from the historical cost of the assets.10
Valuation of FDI stocks
5.23 The BPM5 recommends that all external financial assets and liabilities recorded in the IIP be measured at current market prices as of the dates involved. While market valuations for FDI can be computed where the shares of the direct investment enterprise (or the direct investor) are listed on a stock exchange, difficulties arise in valuing wholly owned subsidiaries and branches, which make up a significant part of overall FDI. For this reason, many compilers use book values from the balance sheets of direct investment enterprises (or the direct investor) to determine the value of the stock of FDI because this represents the only data source that is readily available to them.
5.24 If a country compiles its FDI stock data on the basis of the book value of the direct investment enterprise abroad, there may be large differences between the financial flows recorded in the balance of payments and the resultant change in stocks when transactions involving cross-border M&A are made at prices that exceed the valuations on the books of the direct investment enterprise. The excess over book value would be shown as a valuation adjustment in the reconciliation of changes in IIP positions.
5.25 An increasing number of economies are compiling estimates of FDI stocks on a market value basis, and different approaches are used in deriving these estimates. For example, since 1991 the U.S. Bureau of Economic Analysis has used two measures of valuing FDI positions—the current cost method and the market value method—as an alternative to the book/historical cost basis. The current cost method values the U.S. and foreign parents’ shares of their affiliates’ investment in plant and equipment, using the current cost of capital equipment; in land, using general price indexes; and in inventories, using estimates of their replacement costs. The market value method values the owner’s equity share of direct investment using indexes of stock market prices. The Australian Bureau of Statistics has, since 1985, gathered data on the market value of FDI equity positions directly from surveys of enterprises. For unlisted enterprises, if a market value is not available, the reporting enterprise is asked to estimate the market value by one of the following methods—a recent transaction price, director’s valuation, or net asset value (total assets less nonequity liabilities and less paid-up value of nonvoting shares).11 In the case of Singapore, which recently began disseminating IIP statistics, the Singapore Department of Statistics values only the listed companies at market values, while unlisted companies are recorded at book values. Israel follows a similar practice.
5.26 The United States compiles FDI data on both a market and a book value basis, and the data for 2001 show that for FDI abroad the book value was 60 percent of the corresponding market value. For FDI in the United States, the book value was 52 percent of the market value. U.S. bilateral direct investment data are available only on a book value basis. Hong Kong SAR also publishes stock data on both book and market valuations. Book values and market values are closer—for outward FDI, the book value is 84 percent of market value positions (end-2001), while the book value of the stock of inward FDI is 77 percent of the market value. The closer ratios may be explained by the fact that the FDI stock for Hong Kong SAR reflects more recent acquisitions and investments than the stock of FDI for the United States. Hong Kong SAR bilateral direct investment data are available according to both valuation methods.
Geographic allocation of FDI stocks
5.27 Information on the geographic allocation of foreign financial assets and liabilities (as well as transactions) is useful for analyzing different aspects of a country’s economic and financial relationships. Such data are being compiled for FDI stocks by a growing number of countries. The most common approach employed by countries is to allocate claims to the immediate country of domicile of the direct investment enterprise (host country) and direct investor (investing country), which is in line with the debtor/creditor principle recommended in BPM5.
5.28 However, analysis of geographic detail on the debtor/creditor principle (immediate country basis) may be complicated whenever holding companies are used to channel investments to different countries, including funds that return to the country of the direct investor (“round tripping”). In these cases, the data may simply show large investments in holding companies domiciled in a small number of offshore and other financial centers. As shown in the discussion of imbalances in bilateral data on FDI stocks, the Netherlands excludes SPEs in the geographic breakdowns of its FDI stock data, whereas Canada attempts to allocate positions where the first foreign direct investment enterprise is a foreign holding company to the ultimate country of destination.
5.29 In some economies, the use of enterprises abroad, such as SPEs, for the purpose of round tripping accounts for a significant portion of the overall stock of FDI assets and liabilities. For example, Hong Kong SAR compiles an alternative set of statistics, as supplementary information, to analyze direct investment. These statistics remove the effect of round tripping. Excluding inward/outward FDI from/to “nonoperating companies,” set up by Hong Kong SAR companies in offshore financial centers for indirect channeling of funds, had the effect of reducing the end-2001 stock of inward and outward FDI valued at market prices by 32 percent and 38 percent, respectively.12
5.30 To identify who ultimately owns or controls the affiliate and derives the benefits associated with ownership or control, some countries compile geographic data on the basis of country of ultimate beneficial owner (UBO). Two countries (Denmark and the United States) compile and disseminate geographic breakdowns of inward position data on the basis of the country of the UBO.13 The U.S. Bureau of Economic Analysis defines the UBO as “that person (in the broad legal sense, including a company), proceeding up the affiliate’s ownership chain beginning with the foreign parent, that is not owned more than 50 percent by another person.”14
FDI Investment Income
5.31 The BPM5 standard components for investment income pertaining to the ownership of direct investment capital include income on equity and income on debt. Income on equity is subdivided into (i) distributed income (dividends and distributed branch profits), and (ii) reinvested earnings and undistributed branch profits. In line with the directional recording of FDI transactions, income on FDI is presented on a net basis for direct investment made abroad and in the reporting economy—that is, receipts of income on equity and interest on debt instruments less payments of income on equity and interest on debt instruments. The BPM5 recommends that interest be recorded on an accrual basis. Dividends should be recorded on the date they are payable or declared payable.
5.32 The measurement of operating profits—and, therefore, reinvested earnings—can be affected by the pricing adopted by related parties for bookkeeping purposes, often referred to as transfer pricing. Transfer pricing not based closely on market considerations could be common among affiliated enterprises conducting business across national boundaries because disparities between taxes and regulations imposed by different governments are a factor in management decisions on the optimum allocation of profits among units.15 While BPM5 recommends that, in the relatively rare cases where transfer pricing is identified and quantified, the relevant entry be adjusted to an arm’s length value, compilers can rarely identify and quantify these instances. A recent paper by the U.S. Bureau of Economic Analysis16 considers whether intra-firm trade is conducted at arm’s length prices, or whether prices are set to shift profits and avoid taxes. It concludes that although extensive studies have been made of this topic, no consensus has been reached, and additional data must be collected and further research undertaken.
5.33 Direct investors also earn income through management and other fees and charges levied on direct investment enterprises, which are recorded under business services transactions in the current account of the balance of payments. Although such charges are not separately identified in the standard balance of payments reports shown in BOPSY, data published by countries provide some indication of their significance.17 For example, U.S. receipts of royalties and license fees from direct investment affiliates abroad averaged $24 billion a year during 1999–2001, compared with distributed earnings on U.S. direct investment abroad of $45 billion.18
See the SIMSDI cross-country comparison tables posted on the IMF’s website at http://www.imf.org/external/np/sta/di/mdb97.htm for other examples of differences in compilation practice.
The concept of reinvested earnings does not apply to the balance of payments category of portfolio investment equities.
Deposits, loans, financial derivatives, and other claims and liabilities related to usual banking and financial intermediation activities between affiliated banks and between affiliated financial intermediaries are classified, as appropriate, under portfolio investment, financial derivatives, or other investment in the balance of payments and IIP.
In June 2002, the BPM5 treatment was revised to record financial derivatives involving affiliated enterprises under the category of financial derivatives in the balance of payments and IIP. However, it was noted that some such financial derivatives may not be able to be identified and would, therefore, be included indistinguishably in direct investment (other capital).
These countries include Canada, Mexico, and the United Kingdom.
In addition, at the instruction of the ASEAN Investment Area Ministerial Council, work by ASEAN countries on collecting and reporting of cross-border M&A transactions was initiated, with the first set of such data to be reported to the ministers in September 2003 (Statistics of Foreign Direct Investment in ASEAN, 2002 edition).
Canada, Statistics Canada, Canada’s Balance of International Payments, Fourth Quarter 2001, Page 101, Catalogue 67-001.
Gross external debt, at any given time, is the outstanding amount of those actual current, and not contingent, liabilities that require payment(s) of principal and/or interest by the debtor at some point(s) in the future and that are owed to nonresidents by residents of an economy (see paragraph 2.3 of External Debt Statistics: Guide for Compilers and Users, published by the IMF; see Bank for International Settlements and others, 2003). If an inter-company liability meets this definition, it is part of external debt.
An IMF survey conducted in 1999 in connection with the strengthening of the external debt statistics in the IMF’s Special Data Dissemination Standard (SDDS) showed that nearly half of the 48 reporting countries were able to compile data on short-term external debt (on an original maturity basis) related to direct investment.
Further detail on this type of revaluation can be found in the article “A Guide to BEA Statistics on U.S. Multinational Companies,” in the Survey of Current Business, March 1995. (Also available via the Internet: http://www.bea.doc.gov/bea/articles/internat/usinvest/1995/0395iid.pdf.)
To the extent that assets are not revalued to reflect market values, the calculation of net asset values will have deficiencies as a proxy for market value. However, Australian accounting standards require fairly frequent revaluations of assets.
External Direct Investment Statistics of Hong Kong 2001, Tables IIA and IIC.
Two other countries, Estonia and Portugal, compile, but do not disseminate, geographic breakdowns of inward FDI position data on a UBO basis. In addition, inward position data for Luxembourg compiled on a UBO basis are disseminated in the OECD and Eurostat publications but not in the national publications.
BPM5, paragraph 97.
Although the extended balance of payments services classification presented in the interagency Manual on Statistics of International Trade in Services (United Nations and others, 2002) contains only a residual category relating to transactions between related parties (services between related enterprises), the Manual recommends that data on transactions in services should separately identify, at the total level, transactions with related enterprises and transactions with unrelated enterprises. Statistics Canada, for example, provides a complete breakdown of commercial services transactions between affiliated and other transactors and by type of service. The Manual notes that such information is helpful in understanding the degree to which globalization of services supply is taking place.
Survey of Current Business, September 2002.