Yuko Kinoshita

Foreign direct investment (FDI) is generally considered to be the most stable form of capital flow in a time of distress (Kose and others, 2006; Prasad, Rajan, and Subramanian, 2007; and Tong and Wei, 2010). FDI is also known to bring various benefits to the host country by transferring new technology and know-how and raising productivity and economic growth.

During the global financial crisis of 2007–09, however, FDI proved not so resilient as initially thought (Lane and Milesi-Ferretti, 2011). Most notably, in the crisis-hit Eastern Europe, FDI plunged as sharply as other short-term capital flows—though to a lesser extent—and three years after the crisis, FDI has yet to recover to the pre-crisis level. The reversal of capital flows was particularly pronounced in the Baltics and Southeastern Europe where the countries received sizable FDI in the financial sector and experienced rapid credit growth during the boom period (Bakker and Gulde, 2010).

FDI volatility in the global financial crisis is explained by pre-crisis differences in the sectoral composition of FDI rather than the aggregate FDI. All countries in Eastern Europe received sizable FDI, but the position of external balances was markedly different across countries in the run up to the crisis. A recent study by Kinoshita (2011) argues that the sectoral composition of FDI before the crisis affected external vulnerability through the trade account balance. FDI in the tradable sectors is likely to be associated with better export performance, whereas FDI in the nontradable sectors is positively associated with the incidence of domestic demand booms and often a large deficit in the trade account balance. Among the countries in Eastern Europe, the boom-bust cycles were most pronounced in Southeastern Europe and the Baltics where external imbalances and FDI in the nontradable sectors were sizable. The study also found that countries with large market size, greater trade integration, good infrastructure, and an educated labor force are more likely to receive FDI in the tradable sectors.

The positive effect of FDI on export performance is one of the main benefits to the host country of FDI, and this conclusion is supported by anecdotal evidence as well as past studies. China is a well-known success story of FDI and export growth. In the mid-1980s, China established the special economic zones on its coastal area in which foreign investors were given special incentives to invest, including tax breaks, duty-free importation of capital goods, and a pool of trained workers. Cumulative FDI inflows have continued to grow to date, accompanied by impressive export growth. China’s exports increased ten times between 1995 and 2005, while export share of high-skilled manufactured goods has steadily increased over time. Export promotion and transfer of technology are China’s two most important FDI objectives. The policy mix of discouraging foreign debt and portfolio inflows and providing incentives to FDI further contributed to tilting capital inflows in FDI in the tradable sector (Prasad and Wei, 2007). Using industry-level data, Zhang (2005) finds that FDI indeed has a positive effect on China’s export performance, and FDI’s effect on exports is much larger than that of domestic capital.

“Some argue that the global financial crisis was simply different from past crises because FDI source countries were equally hit hard by the crisis.”

Similar to China’s experience, other developing countries have endeavored to attract export-oriented FDI by offering various incentives to foreign investors in the export sector. Costa Rica launched a proactive attempt to diversify production and exports after the Latin American debt crisis in the early 1980s with the main pillars being FDI promotion and free trade agreements (Moran and others, 2005). Mauritius also transformed itself from an agricultural low-income country to a diversified middle-income country in the span of two decades, initially prompted by the introduction of the export processing zone and FDI inflows that followed.

Other studies also find support for the resilience of FDI in the tradable sectors during the crisis period. Using a worldwide dataset at the establishment level (thus in the tradable sectors), Alfaro and Chen (2010) study how foreign subsidiaries responded to the global financial crisis relative to domestic firms. They find that foreign subsidiaries fared on average better than local firms and that, among foreign subsidiaries, those with stronger vertical production linkages with parent firms exhibited greater resilience. Furthermore, they find that the differences between the performance of foreign and local firms are visible only in the crisis period but not in the non-crisis period.

Some argue that the global financial crisis was simply different from past crises because FDI source countries were equally hit hard by the crisis. Calderon and Didier (2010) find that the scope of mergers and acquisitions (M&A, or fire-sale FDI) was limited during the global financial crisis because this crisis originated in the advanced countries and this explains the very weak recovery of FDI in contrast to previous crises. Moreover, the measurement issue of FDI can also explain the larger-than-expected turnaround of FDI during the crisis. The definition of FDI includes equity capital, reinvested earnings, and other capital (e.g., inter-company loans). Unlike equity capital, the latter two components are more volatile and sensitive to shocks and this also leads to an exaggeration of FDI in good times.

In addition to tradable FDI literature, there is a strand of literature focusing on the effects of nontradable FDI on the host economy—in particular, FDI in the financial sector. Goldberg (2007) gives a useful conceptual framework to distinguish financial and non-financial (e.g., tradables) FDI in her literature survey on FDI. Drawing a parallel between “general” FDI (e.g., manufacturing and resource sectors) and “financial” FDI (e.g., financial sector) in emerging markets, she concludes that the main benefits of FDI such as improved allocative efficiency and technology transfer and diffusion are also found in FDI in the financial sector, albeit with a time lag. But financial FDI seems to affect the incidence of the crisis, business cycle magnitude, and institutional development—this is different from general FDI. Generally, foreign bank entry may introduce a more diversified supply of funds, leading loan supply to be less procyclical, but it could also increase the potential for greater contagion through common lender presence.

More recently, the stability of financial sector FDI during the global financial crisis was examined, focusing on the credit channel of foreign banks. Kamil and Rai (2010) look at the stability of foreign banks’ financing to emerging market countries and find a surprising resilience of foreign bank’s lending growth in Latin America and the Caribbean (LAC) during the crisis. They also show that the propagation of the global credit crunch was significantly more muted in countries where most foreign bank lending was channeled using domestic currency. In a subsequent study, Canales-Kirijenko and others (2010) show that resilience of lending of foreign banks in LAC is attributed to its reliance on domestic deposits rather than loans and capital transfers from parent banks. On the other hand, foreign banks in emerging Europe were more reliant on funding from foreign parent banks, which resulted in faster credit growth before the crisis and also a deeper credit crunch when the crisis hit.

FDI in the financial sector can be a double-edged sword. Though foreign bank ownership generally contributed to increased vulnerabilities before the crisis in Eastern Europe, foreign-owned banks are found to have a stabilizing effect during the crisis (Berglöf and others, 2009; IMF, 2010). In contrast to the Asian financial crisis, Eastern Europe managed to avoid a currency and banking crisis—with a few exceptions—as foreign banks mitigated some of the capital outflows by maintaining their local exposure. For a larger set of emerging economies, however, the overall effect of foreign bank ownership on the economy is mixed. Ostry and others (2010) find that FDI in the financial sector is associated with poor growth performance during the crisis, while FDI in the nonfinancial sector is associated with a better performance.

One of the lessons of the global financial crisis is that the composition of capital flows does matter even for countries with a high share of FDI. On one hand, FDI in the financial sector may bring greater vulnerability as part of it reflects intragroup debt that is more akin to debt than greenfield FDI. On the other hand, FDI in the tradable sector is likely to improve export performance, leading to a more sustainable external balance. In this regard, one should look beyond aggregate FDI and examine the sectoral composition of FDI to assess the overall effect on the host economy. However, the right mix of the sectoral composition of FDI is not the only fix for external vulnerability. Other domestic policies and conditions also should be in place to enhance the benefits of FDI. For example, FDI in the tradable sector does not automatically lead to better export performance in the absence of the absorptive capacity and complementary skills of the host country. Similarly, FDI in the financial sector can play a stabilizing role during the crisis with the help of a supportive regulatory and supervisory framework.