WTO NEWS: 1996 PRESS RELEASES

PRESS/57

9 October 1996

“Trade and foreign direct investment”

New Report by the WTO

In the face of the growing economic, institutional and legal interlinkages between trade and foreign direct investment, should WTO member governments continue to resort to bilateral FDI arrangements? Or should they create a multilateral framework that recognizes these close linkages, and takes into account the interests of all the members of the WTO — developed, developing and least-developed alike?

To assist the trade community in its evaluation of how the WTO should respond to the growing importance of FDI, the WTO Secretariat today (16 October) launched a 60-page report on Trade and Foreign Direct Investment focusing on the economic, institutional and legal interlinkages between FDI and world trade. The report examines the interaction of trade and FDI, including the impact of FDI on trade of home and host countries. It reviews the perceived costs and benefits of FDI, and considers the implications of competition for FDI among host countries. The report also contains a review of the regulations governing foreign investment, together with a brief discussion of existing investment-related WTO rules and disciplines. The report concludes with a review of the key policy issues facing WTO members.

The full text of the report is attached.

Note to editors:

The co-authors — Richard Blackhurst, Director of Economic Research and Analysis Division, and Adrian Otten, Director of Intellectual Property and Investment Division — will hold a media briefing at 3.00 p.m. on Wednesday 16 October in Salle III at the UN Palais des Nations, Geneva. TV, radio and press representatives are invited to attend.

Chapter four

Trade and foreign drect investment

There are many reasons why foreign direct investment (FDI) has become a much-discussed topic. One is the dramatic increase in the annual global flow between 1985 and 1995, from around $60 billion to an estimated $315 billion (Chart 1), and the resulting rise in its relative importance as a source of investment funds for a number of countries. Stocks of FDI, in turn, have been growing and estimates suggest that the sales of foreign affiliates of multinational corporations (MNCs) exceed the value of world trade in goods and services (the latter was $6,100 billion in 1995), that intra-firm trade among MNCs accounts for about one-third of world trade, and that MNC exports to non-affiliates account for another third of world trade, with the remaining one-third accounted for by trade among national (non-MNC) firms.

The keen interest in FDI is also part of a broader interest in the forces propelling the ongoing integration of the world economy, or what is popularly described as “globalization”. Together with the more or less steady rise in the world’s trade-to-GDP ratio, the increased importance of foreign-owned production and distribution facilities in most countries is cited as tangible evidence of globalization.

Foreign direct investment is also viewed as a way of increasing the efficiency with which the world’s scarce resources are used. A recent and specific example is the perceived role of FDI in efforts to stimulate economic growth in many of the world’s poorest countries. Partly this is because of the expected continued decline in the role of development assistance (on which these countries have traditionally relied heavily), and the resulting search for alternative sources of foreign capital. More importantly, FDI, very little of which currently flows to the poorest countries, can be a source not just of badly needed capital, but also of new technology and intangibles such as organizational and managerial skills, and marketing networks. FDI can also provide a stimulus to competition, innovation, savings and capital formation, and through these effects, to job creation and economic growth. Along with major reforms in domestic policies and practices in the poorest countries, this is precisely what is needed to turn-around an otherwise pessimistic outlook.

At an institutional level, the growing importance of FDI, coupled with the absence of binding multilateral rules on national policies toward FDI, has created what in many quarters is viewed as an obstacle that could slowdown the pace of further integration of the world economy. The perceived need for multilateral rules on investment is not new — indeed, the Havana Charter for the stillborn International Trade Organization (origin of the GATT and “spiritual ancestor” of the WTO) contained provisions on foreign investment — but attempts to reach a comprehensive multilateral agreement with binding rules have thus far not been successful.

Renewed interest in FDI within the trade community has been stimulated by the perception that trade and FDI are simply two ways — sometimes alternatives, but increasingly complementary — of servicing foreign markets, and that they are already interlinked in a variety of ways. The 27 OECD countries (plus the EC Commission) are negotiating an investment agreement, scheduled to be completed in time for the 1997 OECD Ministerial meeting. On a multilateral level the WTO’s General Agreement on Trade in Services, by including rules on “commercial presence”, recognizes that FDI is a prerequisite for exporting many services (there are no corresponding rules on commercial presence in the General Agreement on Tariffs and Trade, which governs trade in goods).

It is important to recognize that not everyone is enthusiastic about these developments. Critics are concerned about the possible negative effects of FDI. In “home” countries (where the outflow of capital originates), there are claims that FDI exports jobs and puts downward pressure on wages. In “host” countries (which receive the FDI), there are worries about the medium-term impact on the balance of payments, about potential monopolization of the domestic market, and more generally about the impact of FDI on the government’s ability to manage the economy. Critics are also worried about the implications of having a multilateral agreement that lays down common standards for national FDI rules and requires each signatory to bind its rules under the agreement. Having to bind national FDI policies under a multilateral agreement would be viewed by critics as going even further in pre-empting a country’s right to manage inflows of FDI.

Answers to these concerns are developed below, along with a careful documentation of the many benefits which FDI brings to host countries and which must be considered in formulating a country’s overall attitude toward FDI inflows.

The focus of this report

There is, by now, a fairly extensive academic literature on the general topic of the economics of FDI. In addition, UNCTAD’s annual World Investment Report regularly analyses a variety of aspects of FDI, and extensive statistics on FDI are provided by the IMF, UNCTAD and the OECD. Together this material offers a comprehensive introduction to many FDI-related issues on both a conceptual and empirical level.

From a WTO perspective, the most interesting and relevant aspect of FDI is its interlinkages — economic, institutional, legal — with world trade. With this in mind, it was decided to focus this report on the interlinkages between FDI and trade, rather than on FDI per se. The goal is to help to fill a modest lacuna in the literature, and to assist the trade community in its evaluation of various proposals on how the WTO should respond to the growing importance of FDI.

This introductory section is followed by an examination in Part II of the inter-action of trade and FDI, including the impact of FDI on the trade of home and host countries. Part III reviews the perceived costs and benefits of FDI, and considers the implications of competition for FDI among host countries. Regulations governing foreign investment (other than those in the WTO) are reviewed in Part IV, followed by a brief discussion in Part V of existing investment-related WTO rules and disciplines. Part VI concludes the report with a review of the economic, institutional and legal interlinkages between FDI and trade, and their implications for the options facing WTO members.

Before turning to the main body of the report, however, it would be useful to review briefly a few basic statistics on FDI in order to put the subsequent analysis in perspective (see Box 1 on the definition and measurement of FDI).

Box 1: Defining and measuring foreign direct investment

Foreign direct investment (FDI) occurs when an investor based in one country (the home country) acquires an asset in another country (the host country) with the intent to manage that asset. The management dimension is what distinguishes FDI from portfolio investment in foreign stocks, bonds and other financial instruments. In most instances, both the investor and the asset it manages abroad are business firms. In such cases, the investor is typically referred to as the “parent firm” and the asset as the “affiliate“ or “subsidiary”.

There are three main categories of FDI:

• Equity capital is the value of the MNC’s investment in shares of an enterprise in a foreign country. An equity capital stake of 10 per cent or more of the ordinary shares or voting power in an incorporated enterprise, or its equivalent in an unincorporated enterprise, is normally considered as a threshold for the control of assets. This category includes both mergers and acquisitions and “greenfield ” investments (the creation of new facilities). Mergers and acquisitions are an important source of FDI for developed countries, although the relative importance varies considerably.

• Reinvested earnings are the MNC’s share of affiliate earnings not distributed as dividends or remitted to the MNC. Such retained profits by affiliates are assumed to be reinvested in the affiliate. This can represent up to 60 per cent of outward FDI in countries such as the United States and the United Kingdom.

• Other capital refers to short or long-term borrowing and lending of funds between the MNC and the affiliate.

The available statistics on FDI, which are far from ideal, come mainly from three sources. First. there are statistics from the records of ministries and agencies which administer the country’s laws and regulations on FDI. The request for a license or the fulfilment of notification requirements allows these agencies to record data on FDI flows. Typically, re-invested earnings, intra-company loans, and liquidations of investment are not recorded, and not all notified investments are fully realized in the period covered by notification. Second. there are the FDI data taken from government and other surveys which evaluate financial and operating data of companies. While these data provide information on sales (domestic and foreign), earnings, employment and the share of value added of foreign affiliates in domestic output, they often are not comparable across countries because of differences in definitions and coverage. Third. there are the data taken from national balance-of-payments statistics, for which internationally agreed guidelines exist in the fifth edition of the IMF Balance of Payments Manual. The three main categories of FDI described above are those used in balance-of-payments statistics.

At present, many countries — including some G.7 countries — have not yet fully implemented the IMF guidelines (in particular, re-invested earnings and inter-company transactions are not always covered), which impairs the comparability of FDI data across countries. In addition, a large number of developing countries do not provide FDI data. UNCTAD’s 1995 World Investment Report had to rely on OECD partner statistics to estimate FDI flows for about 55 economies. Despite recent improvements, more efforts at the national level are needed before comparable and reasonably comprehensive FDI data will be available at the global level.

Recent trends in FDI

Chart 1 above spans a little more than two decades. By the end of the 1970s, the annual outflow of FDI from OECD countries to all destinations (including one another) had doubled from around $25 billion to nearly $60 billion (the OECD countries currently are host to 73 per cent, and home to 92 per cent of the world’s stock of FDI). These are nominal figures, however, and recalling that the OECD countries went through two periods of double-digit inflation in the 1970s, it is clear that in inflation-adjusted real terms there was little or no increase in the annual outflow. After declining sharply in the early 1980s, it began once again to increase. During the years 1986 to 1989 annual FDI flows increased at a phenomenal rate, multiplying fourfold in four years. In the second half of this four-year burst of activity, the global total was given a further boost, albeit a minor one, by a tripling (from a very low base) of FDI outflows from non-OECD economies, in particular from Hong Kong. More specifically, the share of non-OECD countries in worldwide outflows of FDI increased from 5 per cent in 1983-87 to 15 per cent in 1995.

In the OECD countries, this period of high growth for FDI was followed by five years (1990-94) of stagnant or declining annual outflows, no doubt reflecting in part the widespread economic slowdown. Then, in 1995, there was another dramatic turn-around, with outflows of FDI from the OECD area estimated to have increased by 40 per cent.

A commonly asked question is whether FDI is growing more rapidly than world trade. The answer depends on the period. During 1986-89 and again in 1995, outflows of FDI grew much more rapidly than world trade. In contrast, during 1973-84 and 1990-94, FDI growth lagged behind trade growth. Over the entire period 1973-95, the estimated value of annual FDI outflows multiplied more than twelve times (from $25 billion to $315 billion), while the value of merchandise exports multiplied eight and a half times (from $575 billion to $4,900 billion).

A comparison of flows of FDI and flows of international portfolio investment for the period 1988-94 reveals that the average annual flows of the two types of international investment were more or less equal during 1988-90, after which portfolio investment began three years of rapid growth that brought it to a level ($630 billion in 1993) more than double that of FDI. A sharp slowdown in the growth in portfolio investment in 1994 then narrowed the gap somewhat (data on portfolio investments for 1995 are not yet available). A third category of financial flows, and one of particular importance to many developing countries, is official development finance. In 1994, when the flow of international portfolio investment was about $350 billion and the flow of FDI $230 billion (in both cases to all destinations), the OECD countries provided about $60 billion of official development finance, of which about $50 billion went to developing countries and the remainder to the transition economies.

In 1995, inflows of FDI into the non-OECD area totalled an estimated $112 billion. Of this, approximately $65 billion went to Asia, and another $27 billion to Latin America (including Mexico). The remaining $20 billion was divided almost equally between transition economies in Europe on the one hand, and Africa and the Middle East on the other.

The share of the non-OECD countries in world FDI inflows, which decreased in the 1980s, increased from nearly 20 to about 35 per cent between 1990 and 1995. China as a host country played a major role in this increase, but other developing countries, in particular in Asia and Latin America, have also benefited from a sharp increase in FDI. At the same time, FDI flows to non-OECD countries are highly concentrated. In 1995, China accounted for about one-third of all FDI inflows into non-OECD countries ($38 billion out of $112 billion), and another nine countries for another 35 per cent. The remaining 31 per cent or $36 billion was divided (not equally) among the approximately 135 remaining developing and transition countries. The least-developed countries attracted throughout the 1990-95 period on average $1.1 billion of FDI inflows which corresponds to about one-half of 1 per cent of global FDI flows.

Switching to cumulative inflows. Table 1 presents figures on aggregate cumulative inflows into the leading host economies for the period 1985-95. Seven out of the twenty are developing economies. China is in fourth place, with Mexico, Singapore, Malaysia, Argentina, Brazil and Hong Kong, also on the list. Table 1 also calls attention to the fact that the leading host economies for FDI are, for the most part, also the leading home economies for FDI (the names of the latter are in bold). The first nine host economies, plus seven of the remaining eleven host countries, are on the list of the twenty leading home economies.

Table 1

Leading host economies for FDI based on cumulative inflows, 1985-95