Attracting foreign direct investment (FDI) for nearshoring will play a key role in Latin America and the Caribbean’s economic recovery and sustainable growth after the COVID-19 crisis.
However, countries in the region need to design targeted investment attraction strategies if they are to attract production activities currently based in other areas of the world, such as Asia. This is one of the conclusions reached in a new IDB study, Foreign Direct Investment: Definitions, Determining Factors, Impacts, and Public Policies, which seeks to explain the 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 entity that is resident in one economy (a direct investor) seeks to obtain an abiding interest 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 not entail any 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 keys for host countries designing investment attraction policies, for which they receive support from Investment Promotion Agencies.
There are four types of FDI: natural resource-seeking, market-seeking, efficiency-seeking, and strategic 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 to exploit natural resources, the availability of which is the main location advantage offered by the host country. In the past, these kinds of investments often created enclaves 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 building a presence in major markets or following clients 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 rationalize the multinationals’ production to make the most of economies of specialization and scope while diversifying risk. MNCs pursuing such strategies take advantage of differences in factor endowments, local capabilities, public policies, demand patterns, and cultural norms to concentrate different production lines in other locations.
These strategies are favored by liberalization and 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 investment firm to maintain or increase its global or regional competitiveness. The strategic assets sought by multinationals may range from innovation capacities and organizational structures to distribution channels or better understandings of consumers’ needs in new markets. Mergers and acquisitions are often associated with this type of strategy.
Finally, recent empirical research suggests that considerable diversity exists in 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 macroeconomic and microeconomic impacts of Foreign Direct Investment
The impacts of FDI can be divided into two categories: the macroeconomic and the microeconomic.
When it comes to macroeconomic impacts, 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 greenfield investments or capacity expansions. In the latter case, FDI can be expected to impact economic growth and job creation positively.
From the microeconomic perspective, FDI can generate a set of positive externalities associated with transfers of 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, the sign 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, and the 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 and aerospace industries) is a very different undertaking to attracting investment in extractive sectors with limited local linkages.
FDI, vital for Latin America and the Caribbean’s post–pandemic future
FDI will play a decisive role in LAC’s growth and development after the COVID-19 pandemic, especially if there is a widespread nearshoring of GVCs. This supply chain realignment calls 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 to 2% between 2010 and 2018). This has happened in tandem with the slowed growth of globalization brought on by the global systemic crisis. The COVID-19 crisis is likely to reinforce this trend, given the protectionist pressure and trade tensions between the major global economies and a move toward reshoring and nearshoring, making value chains more regional than global.
Latin America and the Caribbean has maintained a relatively high and stable share of global FDI flows, averaging between 8% and 9% in recent five-year periods. However, except for Mexico, its role in GVCs has 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 the nearshoring of activities that are currently based in other parts of the world.
One lesson that emerges after analyzing other successful experiences is that FDI promotion policies should be complemented by instruments that seek to 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.