The right foreign direct investment (FDI) can transform a developing country. Its potential for transformation goes beyond just generating higher economic growth numbers for a few years.
The more important aspect of FDI is that it brings to a less developed country a ready-made package of capital, skills training, new technology, market access, product development and branding and management capacity that would take a country a generation to replicate. This is why FDI has been instrumental in the economic development successes of regions such as Southeast Asia and Eastern Europe.
In this context, the latest issue of the World Investment Report (WIR) by the United Nations Conference on Trade and Development is an important read. It provides us with insights into how FDI could continue to drive economic development in Asia, and, indeed, there is a lot of good news for Asia in this report.
One encouraging takeaway is that overall global investment is holding up despite all the political, financial and other bad news the world has faced. Also positive is that greenfield FDI or FDI in actual factories and services industries, as opposed to financial investment flows, has continued to grow.
More than that, the determinants of multinational corporations’ decision-making on FDI are shifting, creating a new pattern of winning countries. India and Southeast Asia will be among the winners, but they must work harder to ensure this.
Capital spending holds steady despite headwinds
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It is striking to see the number of greenfield foreign direct investment projects surging by 15% to 17,000 in 2022, with the value of such projects ballooning by 64%. This happened in a year when a never-ending flow of bad news hammered business confidence.
The crisis in Ukraine brought war back to Europe after decades of peace and shook up the world economy as big power frictions worsened and supply chain bottlenecks reinforced a spike in energy, food and other prices.
The year saw high inflation and growing worries that the harshest tightening of monetary policy could cause a worldwide recession. And it was a period of great uncertainty in China, the second-largest economy in the world.
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It is worth emphasising that this resilience in capital spending seems to continue this year, at least in the US, for which we have good data. There, the first quarter of this year saw gross fixed capital formation expanding by 7.92% y-o-y to reach US$21.3 trillion ($28 trillion), despite a higher cost of capital caused by numerous Federal Reserve (Fed) rate hikes and despite a tightening of lending standards by commercial banks, which made it difficult for borrowers.
Looking into the future, growth in US capital goods orders has bounced again in the past couple of months after slowing, suggesting that businesses in America are looking beyond the immediate challenges and are keen to invest for the longer term.
There are longer-term structural forces that are encouraging entrepreneurs to grow their capital spending. The reconfiguration of supply chains accelerates as frictions between the US and China have worsened.
Many firms find that they have little choice but to restructure their manufacturing footprint to mitigate risks, even if it means higher production costs and less efficiency. Spending on decarbonisation is also ratcheting up due to regulatory changes and pressures from consumers and other stakeholders.
Global companies see expanding middle-class spending in large developing economies such as India and want to tap into these new markets, which would involve producing locally in many cases. Finally, there are also massive new opportunities to improve profitability due to technological innovation.
FDI shifting from China to developing economies
Another trend at the global level is that FDI is shifting away from developed economies towards developing ones, as seen in the diminishing share of developed economies in global FDI flows. According to the WIR, developing countries accounted for more than two-thirds of global FDI in 2022, up from 60% in 2021.
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Emerging economies in Asia have been the main gainers in this shift, although there has been an uptick in the share of Latin American economies of late as well. Within the Asian region, greenfield investors seem to be favouring other Asian emerging economies, such as Asean countries and India, over China. In 2022, Asean’s share of global FDI exceeded China’s by 2.6 percentage points (pp).
This is a notable development, as the last time Asean outperformed China by such a large margin was in 1991. At the same time, while India’s share of global FDI pales compared to China and Asean, the country is enjoying an upward trajectory in attracting FDI.
It is important to understand why these shifts are occurring — they seem to be part of a longer term trend of portfolio rebalancing by foreign investors following years of overweighting Chinese investments.
In the 1990s, as China made progress in much-needed reforms and as its entry into the World Trade Organisation looked more and more likely, global firms decided to substantially increase China’s share of their global portfolio of investment locations.
Consequently, China’s share of global FDI flows soared from a meagre 1.7% in 1990 to a peak of 13.2% in 1994. The country’s rise came partly at the expense of Asean, which found its share stagnating, especially following the Asian Financial Crisis, which devastated several Asean economies.
China’s challenges and improvements in Asean’s investment environment have prompted global firms to rebalance their portfolios again, this time in favour of Asean and other regions like India over China.
The value of announced greenfield projects in China decreased sharply by 43%, while the number of announced greenfield projects declined by 26% to 357. The slowdown in 2022 is part of a downward trend that began in 2018.
We believe China’s share will continue to edge down for several reasons.
• China can no longer be considered a low-labour cost production base as wages rise with growing prosperity and as a shrinking working-age population reduces the supply of workers. The average annual wage of urban private employees more than doubled from sub-RMB30,000 in 2012 to RMB63,000 in 2021, making many industrial centres in China now more expensive than even middle-income Asean countries such as Thailand and Malaysia.
• This has reduced the profitability of foreign investment in China. Data on US investments in China show that the return on capital for US investors in China declined from 19.4% in 2007 to 10.4% in 2021. While China still offers a return on investments above the global average, the degree of the premium it offers has declined over time, and it now underperforms regional rivals Indonesia and India, which boasted returns of 24.4% and 12.4%, respectively.
• The business environment in China itself has been rocked by regulatory and policy changes that have unsettled foreign investors, rattled by the severity of the measures taken to control the pandemic. The European Union Chamber of Commerce’s 2023 Business Confidence Survey revealed that 64% of respondents reported that doing business in China became more difficult in the past year, the highest on record. Beijing’s revised Counter-Espionage Law, which took effect on July 1 and gives authorities even more power to punish foreign firms and individuals deemed a threat to national security and the party’s tightening grip on private enterprises, only worsens investors’ confidence.
• Amid greater geopolitical tensions, foreign firms — especially those operating in sensitive industries — are under increasing pressure from their domestic governments to disengage from China. Strong funding and tax breaks, such as those under the administration of US President Joe Biden’s Inflation Reduction Act, provide further impetus for multinational enterprises to re-shore or nearshore production.
However, China retains considerable advantages, and FDI will flow to China in large volumes even if its share of the global total edges down. After all, China retains immense competitive positioning in areas such as chemicals, electric vehicles, and various forms of machinery. This is why the European chemicals giant BASF committed itself to a US$10 billion investment in new chemical plants in China.
Can Asean and India gain from these shifts?
Rebalancing global firms’ production locations has helped raise Asean’s share of global FDI flows by 2.8 pp to 17.2% and the value of announced greenfield projects by 35% to US$86.6 billion. Companies are eager to tap into the region’s low wages due to a burgeoning young population — its median age is 30, while that of China is 38.
As Asean workers are well-equipped with specialised skills, wages in Asean economies such as Indonesia, Malaysia and Thailand are some of the most cost-competitive in the world after adjusting for productivity. Moreover, Asean’s expanding middle class of 140 million new consumers by 2030 is also proving lucrative for foreign firms.
Within Asean, Vietnam and Indonesia have emerged as stand-out winners. For Vietnam, the value of its announced greenfield FDI projects increased by 120% to US$ 26 billion in 2022. Vietnam has established itself as a global electronics production hub over the last decade and has drawn rich investments from electronics giants Samsung and LG, with another US$ 6 billion of investments between them announced in December last year alone.
Indonesia enjoyed strong growth in the value of announced greenfield FDI projects which increased by 82% to US$15 billion. With its abundance of nickel, a key component in producing electric vehicle (EV) batteries, Indonesia aims to be the global EV manufacturing hub by 2027.
India, too, is wooing international investors with more success, with announced greenfield projects there expanding by 276% to US$78 billion in 2022, far exceeding China’s US$18 billion. India is also working hard to address its structural shortcomings.
With ambitious programmes such as the National Master Plan for Multi-modal Connectivity Plan and the National Logistics Policy, the Indian government seeks to trim logistics costs from the current 14% of GDP to less than 10%. It still needs to do more, particularly in skilling its workforce, to sustain its gains in securing a higher share of global FDI.
Winds are blowing in Asia’s favour
The global investment environment is changing to benefit Southeast Asia and other emerging Asian markets such as India. These markets cannot replicate all the advantages that China used to offer, but they provide enough positives to lure more investment their way.
Suppose India and Asean can continue improving their business environments by liberalising investment regulations, rationalising labour laws, taking physical infrastructure to a higher level and offering incentives for foreign investors.
In that case, the likelihood is that the shifts in FDI we have seen lately will persist, allowing these regions to enjoy a higher-quality economic development surge.
Manu Bhaskaran is CEO at Centennial Asia
