Thursday, October 27, 2016

Is Foreign Direct Investment Mostly Portfolio Flows in Disguise?

What if the very commonly used distinction between foreign direct investment and portfolio investment is basically not supported by existing data? Olivier Blanchard and Julien Acalin raise this possibility in "What Does Measured FDI Actually Measure?" written for the Peterson Institute of International Economics (October 2016, Policy Brief 16-17).  

Here's why the question matters: At an intuitive level, portfolio investment is supposed to be about financial flows, while foreign direct investment is about investments that involve a degree of ownership and responsibility. Thus, when thinking about the possible dangers of international capital flows, it's common to focus on the risks of portfolio investment zooming in and out of a country, and how this can lead to stock market boom and bust, sharp fluctuations in exchange rates, and even banking and financial crises. In contrast, the usual assumption is that foreign direct investment is much less mobile, and that it involves tighter connections across markets and global supply chains, along with transfers of technology and expertise. Thus, discussions of the potential dangers of international capital flows often focus on whether it's possible to put some restraints on portfolio flows, while not hindering foreign domestic investment.

Blanchard and Acalin look at the actual data on foreign direct investment, and find that it's often behaving more like portfolio investment, with some pattern that suggest it is driven by a desire to shift resources across borders in a way that reduces corporate taxes. They write (footnotes omitted):

"Conventional wisdom on capital flows holds that FDI inflows are “good flows,” while assessments of portfolio and other flows are more ambiguous. When considering restrictions on capital flows, the first reaction of researchers and policymakers is to want to exclude FDI inflows.
"In looking, however, at measured FDI flows to emerging markets (in the course of a larger project on capital flows), we have found three facts that suggest that measured FDI is actually quite different from the depiction of FDI above. The first is a surprisingly high correlation between quarterly FDI inflows and outflows. A reasonable prior would be that this correlation should be close to zero or even negative: If a country is for some reason more attractive to foreign investors, it is not obvious why domestic investors would want to invest more abroad, especially within the same quarter. The second is an increase in quarterly FDI inflows to emerging-market countries in response to decreases in the US monetary policy rate. Again, a reasonable prior would be that FDI flows do not respond much, if at all, to changes in the policy rate within a quarter—i.e., the effect should be close to zero.  ... The third fact, closely related to the first two, is an increase in quarterly FDI outflows from emerging-market countries in response to decreases in the US monetary policy rate. Again, a reasonable prior would be that FDI outflows do not respond much, and, if they did, they would decrease in response to a decrease in the US policy rate. This is not the case.
"These facts suggest two conclusions. The first is that, in many countries, a large proportion of measured FDI inflows are just flows going in and out of the country on their way to their final destination, with the stop due in part to favorable corporate tax conditions. This fact is not new, and, as discussed below, countries have tried to improve their measures of FDI to reflect it. But the magnitude of such flows came to us as a surprise.
"The second is that some of these measured FDI flows are much closer to portfolio debt flows, responding to short-run movements in US monetary policy conditions rather than to medium-run fundamentals of the country. ...
"FDI inflows and outflows are highly correlated, even at high frequency and using different methodologies. FDI flows to emerging-market economies appear to respond to the US policy rate, even at high frequency. This suggests that “measured” FDI gross flows are quite different from true FDI flows and may reflect flows through rather than to the country, with stops due in part to (legal) tax optimization. This must be a warning to both researchers and policymakers."
For more inforrmation on these issues, one common  source for foreign direct investment is an annual report from UNCTAD, and I discuss one of their recent reports in "Snapshots of Foreign Direct Investment Flows" (September 8, 2015). The most common source for portfolio investment is an annual report from the IMF, and I discuss one of their reports from a few years back in "International Portfolio Investment in 2012" (December 9, 2013).