COVID-19 and the global contraction in foreign direct investment

By Adnan Seric, Research and Industrial Policy Officer at the Department of Policy Research and Statistics (PRS) at the United Nations Industrial Development Organisation (UNIDO), and Jostein Hauge, Research Fellow at the Centre for Science, Technology, and Innovation Policy (Institute for Manufacturing) at the University of Cambridge

This blog is part of a series on tackling COVID-19 in developing countries. Visit the OECD dedicated page to access the OECD’s data, analysis and recommendations on the health, economic, financial and societal impacts of COVID-19 worldwide.

shutterstock_163440290COVID-19 is uprooting economic globalisation. As both supply and demand are experiencing simultaneous shocks due to lockdown measures, global production networks and international trade flows are being disrupted on a scale never seen before. Disruptions to flows of portfolio and foreign direct investments (FDI) — which are part and parcel of economic globalisation — are no exception. According to the International Monetary Fund, investors removed over US$100 billion of portfolio investment from developing countries since the beginning of the COVID-19 crisis, the largest capital outflows ever recorded. According to the UN Conference on Trade and Development (UNCTAD), global FDI flows are expected to contract by 40% during 2020/21.

The contraction in FDI is going to hit developing countries particularly hard, mainly for two reasons. First, FDI inflows to developing countries are expected to drop even more than the global average seeing that sectors that have been severely impacted by the pandemic account for a larger share of FDI inflows in developing countries. Second, developing countries have become more reliant on FDI over the last few decades — FDI inflows to developing countries increased from US$14 billion to US$706 billion (current prices) between 1985 and 2018, as seen from Figure 1. As a share of world FDI inflows, this represents an increase from 25% to 54%.

Figure 1: FDI inflows to developing countries 1985-2018, US$ billion (current prices)

foreign direct investment 1

Source: UNCTAD STAT datacentre:

FDI inflows to developing countries are not uniform in either quantity or quality. Fast-growing economies in Asia with large populations have been driving the surge over the past few decades, most importantly China, but also Cambodia, India, Indonesia, Malaysia, Myanmar, Philippines, Thailand, and Vietnam. The inflows of investments into these countries are mainly concentrated in manufacturing and services. If we look at dependence on FDI inflows rather than their quantity, African countries enter the picture (see Figure 2, which depicts the five countries in the world most dependent on FDI inflows). They tell a different story than the countries in Asia. In Africa, most FDI inflows still focus on the extractive industries, such as oil and mining. This type of FDI tends to be more volatile, which explains the huge swings in FDI inflows in the cases of Congo and Mozambique. In Ethiopia, growth in FDI inflows is concentrated in the manufacturing sector. 

Figure 2: Top five developing countries most dependent on FDI inflows, as measured by FDI inflows as % of GDP (minimum US$ 3 billion in FDI inflows in 2018)foreign direct investment 2

Source: UNCTAD STAT datacentre:

If we assume that the contraction in global FDI will last for a while, the consequences will be severe for developing countries. But it will impact them in different ways. For those countries that are dependent on FDI inflows in the extractive sectors, many of which are in Africa, they will most importantly experience a loss in export and tax revenues. For those developing countries that have a more diversified portfolio of FDI inflows, the consequences of a global FDI contraction could be even more serious because the potential benefits of FDI inflows are greater. FDI inflows not only boost export revenues in the case of these countries, but also boost employment to a greater extent, tend to have a more positive impact on infrastructure development, and can result in technology transfer to the host economy (particularly in the manufacturing sector). In addition to a loss of investment, we can expect that many investors will stop their plans for expansion.

We should also worry about a contraction in FDI to developing countries due the nature of competition in the 21st century global economy. The competition among developing countries to attract FDI from high-income countries and/or serve as suppliers for consumer markets in high-income countries is fiercer than ever, particularly in manufacturing. The developing-country share of low-tech manufacturing exports has almost tripled since 1980, and the global pool of unskilled labour has doubled since 1990. This means that reopening production quickly, perhaps even before it is safe to do so, can provide a competitive edge. For example, in Bangladesh, garment manufacturers have been put under pressure to restart production despite the health risk associated with doing so. Factory owners are worried that if they don’t resume production quickly, overseas retailers will simply source production from China, Vietnam, or Cambodia. In other words, for many developing countries there is unfortunately a clear trade-off between respecting the health risks associated with COVID-19 and retaining a competitive edge.

This crisis may offer a window of opportunity for governments to re-examine their approaches to investment attraction and retention. To this end, we highlight two areas that may require novel policy thinking and thus increased attention of policy makers:

First, measures should focus on increasing the embeddedness of FDI within host economies. Measures that have proven to be successful include the development of quality certification systems (which are often required to operate with foreign firms), improvements in digital infrastructure that allow firms to operate remotely both along global value chains and in reaching out to foreign markets, and the design of export processing zones (EPZs), that support match-making processes between foreign firms and local suppliers.

Second, international action to support countries during and after this pandemic need to pay particular attention to least developed countries. These countries are facing particularly hard budget constraints and are often limited to implementing policies that focus mostly on investment facilitation measures, simply because they do not have the resources to offer more substantive financial support to the private sector.

This is why it is crucial that international organisations and country groupings, like the United Nations and G20, respond to calls for support especially from least developed countries, from ensuring access to essential imports, to providing administrative support and keeping supply chains alive.

The pandemic and the crisis have shown, once more, the importance for developing countries, especially Least Developed Countries (LDCs), to reduce the vulnerability and risks associated with concentrated production structures and limited industrialisation. The response to the crisis can and should be a catalyst to putting investment for production transformation at the forefront of the agenda and achieving greater resilience and sustainability.