Global Insight Perspective

Significance

After several years in the doldrums, foreign direct investment (FDI) rebounded impressively in 2004 as growth picked up in key economies and companies rediscovered their appetite for mergers and acquisitions. The latest World Investment Report data for 2005 show that this was no one-off, but flows are still a long way off their 2000 peak.

Implications

The figures have to be approached with some caution as a handful of large mergers can skew the data dramatically. Nevertheless, even when one strips out the corporate activity among developed nations, many poorer countries who rely heavily on FDI to spur development recorded exceptional years in 2005.

Outlook

Evidence to date shows that 2006 will almost certainly register further growth in FDI, driven by robust economic activity, persistently high commodity prices and strong stock market performance. The upward path is by no means guaranteed in subsequent years, however, and there is a heavy onus on governments to improve their regulatory environments.

Unpicking the Trends

The key role that foreign direct investment (FDI) can play in fostering development is well known, but collecting reliable statistics when flows are so liquid and multi-directional is a huge task. Over the years the United Nations Conference on Trade and Development (UNCTAD) has acquired a reputation as the most authoritative source for such data, and its flagship World Investment Report consequently receives a great deal of attention. The final data and analysis for 2005 were released earlier this week, and the report shows that total inflows amounted to some US$916 billion, up 29% on 2004. The latter year was itself up 27% on 2003. The 2005 findings corroborate piecemeal data that individual countries had previously released. Even after this impressive growth the inflows are still a long way off the record US$1.4 trillion witnessed in 2000. Flows plummeted in subsequent years as stock market bubbles burst and companies retreated to lick their wounds.

While much of the growth in 2005 was driven by an exceptional pattern of mergers and acquisitions (M&As) among wealthy economies (up 88% over 2004 to US$716 billion), it is encouraging to see that flows picked up in all sub-regions. Total FDI to developing countries was a record US$334 billion in 2005, while in developed countries the total stood at US$542 billion. This is not to say that all countries benefited similarly—74 of 200 countries covered showed no growth or decline. One region where FDI is particularly important for economic prospects is sub-Saharan Africa. It celebrated a record year in 2005, attracting US$11 billion in total, thanks largely to heavy interest in natural resources. This does remain a long way behind other emerging markets, nonetheless, and the attractions of high commodity prices will not last indefinitely.

At the centre of the M&A surge was the United Kingdom, the single largest FDI recipient in 2005 with US$165 billion. The United Kingdom's high degree of privatisation and deregulation has always made it an attractive destination for investors, but it had fallen behind some of its European counterparts in recent years. Overall, the 25-member European Union (EU) claimed almost a half of the world total, well ahead of the fifth share claimed by Asia. Europe was the focus of most M&A "mega deals" (worth over US$1 billion), of which there were a total of 141 over the year. U.S. inward investment was down, meanwhile, but it still claimed second spot in the individual country ranking. Among individual developing countries, China and Hong Kong unsurprisingly led the field once more. There was encouraging performance from key Latin American economies that have under-performed in the past, notably Mexico (fourth) and Brazil (fifth). Singapore took the third spot.

Looking briefly at outflows of FDI worldwide, which are actually lower than inflows at US$779 billion due to statistical quirks, the major sources are not dissimilar to the major destinations. The Netherlands claimed the number-one spot due mainly to Shell's merger, and was followed by France and the United Kingdom. Promisingly, outflows are also increasing from developing countries (17% of the total in 2005). Chinese (and Hong Kong) investment in regions such as sub-Saharan Africa is becoming increasingly significant to the wider FDI picture. One country notable for lower outflows in 2005 was the United States. An important factor behind this was the 2004 American Jobs Creation Act that encouraged repatriation of U.S. firms' overseas earnings with lower taxation.

This article now takes a closer look at the trends region by region.

Asia-Pacific—Lion's Share for China, India Trails

FDI into South, South-East and East Asia amounted to an impressive US$165 billion in 2005, which equates to 18% of all FDI inflows globally. Around one-half of all inflows came from developing economies, most from within the Asia region. The majority went to China (US$72 billion) and Hong Kong (US$36 billion), with US$37 billion going into South-East Asia, where Singapore (US$20 billion) proved the main draw, and just US$10 billion going into South Asia. The significant disparity in FDI inflows between China and India remains clear, with India netting a meagre US$7 billion. That said, the report praised both nations for taking notable steps to open up their economies in 2005, with China taking measures in its banking and travel sector and India opening up construction and retail to greater foreign participation.

Manufacturing FDI was singled out as notably increasing into the whole region, while within the region itself, changes in patterns of manufacturing FDI have been registered as countries have moved up the value-added ladder. Sectors that continue to attract large amounts of FDI include automotives, electronics, steel production and petrochemicals.

Interestingly, although all three subsets of the region are emerging as sources of FDI, this percentage dropped by 11% year-on-year (y/y) to US$68 billion. Nevertheless, the report’s authors regard this as a fillip, particularly given that Chinese outflows for 2006 look set to increase, with no change in this pattern expected.

Europe–M&A Activity Surges, Central Europe Continues to Attract

The EU, now comprising 25 countries (and rising to 27 countries from 2007), accounts for nearly half of all global inward and outward investment flows. Between 2003 and 2005, the report notes that the share of the "Triad" (EU, Japan and U.S.) inward investment directed to the EU rose to 75%, from levels of 62% between 1978 and 1980. However, investment between EU countries has increased, as has EU investment in its "Near Abroad". The EU is driving greenfield investment in south-eastern Europe and the CIS, but also seeing gains from the remaining privatisation deals on offer. The sectors of interest vary nationally: Austria has seen considerable consolidation in financial markets and banking, and Netherlands-based companies (often for tax and operational purposes) have made considerable investments in commodities markets—for example, the steel sector. A dip in German investment to negative territory in 2004 (largely resulting from intra-company loans) was reversed; however, confidence remains fragile, and compared to the tripling of investment into the United Kingdom, there is still work to be done to restore investor momentum. In the central European region investment has remained strong, but the Czech Republic is an investment champion, having in total attracted more than neighbouring Poland, despite being one-quarter of the size in population terms.

In south-east Europe and the CIS (19 countries in this definition), the report notes that 2005 saw hardly any change in the volume of investment, at around US$40 billion. However, FDI into the Central Asian regions still seems to be on a country or project/sectoral basis, rather than increased interest in the region in general, and this left inflows uneven. In sector terms, energy is a major area of investment in the region, but since one large project can swing FDI figures, some states saw investment percentages drop in 2005 because major projects in 2004 had pushed figures higher. The lucrative single deals often increase the temptation of governments to levy one-off windfall taxes.

Romania, Russia and Ukraine were by far the three largest recipients, with a large swathe of investment coming from EU members. Romania certainly can expect this figure to rise as a result of EU accession in 2007, with the investment agency confirming this week that 2006 is expected to be a bumper year. Russian investment may be more uncertain in the short term, with recent clampdowns by the government in foreign participating contracts having sent jitters through the investment community that may send them into Central Asia in search of lucrative energy contracts elsewhere. The Uzbek government's targeting of U.S.-connected investors may, however, act as a cautionary tale; following its decision to declare gold-mining giant Newmont Corp. insolvent, it has begun to pursue other U.S. firms and non-governmental organisations.

Latin America and the Caribbean—Good Performance in 2005, but Political Concerns Mount

Foreign investment inflows increased again in Latin America and the Caribbean in 2005, building up on 2004’s trend. With a global backdrop characterised by high commodity and oil prices, Latin America’s primary sector captured a large share of FDI flows—the oil and gas industry accounting by-and-large for the substantial 40% inflow increase. The manufacturing sector—boosted by M&As and FDI to Mexico and Brazil and the notable paper plant investment in Uruguay—also gained in importance, while FDI to the service sector continues its decreasing tendency begun in 2001. Despite increasing FDI and a positive international context, Latin American countries still face a relentless social deficit. With this in mind they have generally shifted away from the minimalist state rationale of late, intervening more heavily and attempting wealth redistribution. More radical governments have even moved towards regaining full or partial control over strategic economic sectors, in particular on coveted natural resources. These have for now failed to have a significant impact, but medium-term analysis of FDI flows could tell a different story. The changed political landscape has also started to shift the region's trade politics and patterns, delaying negotiations on free-trade accords (Ecuador). At the same time there is considerable appetite for cross-continent bilateral agreements, in particular with booming Asia.

A glance at geographically disaggregated FDIs flows shows that regional heavyweights Brazil and Mexico were once again the chief recipients of FDI, although emerging players such as Colombia snatched a substantial share, indicating that investor confidence is still buoyant on the back of President Alvaro Uribe’s security policies and reformist stance. Mexico was also at the vanguard of Latin American countries reinvesting in the region, dedicating US$6.2 billion in 2005. The offshore financial sector, a major source of income in the Caribbean, lost out last year partly as a consequence of tough anti-terror legislation in the United States. Venezuela and Ecuador got away with passing unpalatable energy legislation, securing strong investment in the oil and gas sector, which gained the lion’s share of FDI—up by 65% and 61% overall in the respective Andean nations. The long-term impact of energy policies unfriendly to foreign business remains to be seen, but the losses recorded in Bolivia, troubled with policy inconsistency and a broad-based nationalisation programme, act as a sober warning. Uruguay looked like the darling of the investor community, recording an 81% increase on the previous year, but funds stem from the unpopular paper mill projects that could still be cancelled by international arbitrators.

Middle East—Strong Inflows Despite International Context

Despite continued geopolitical uncertainties in the Middle East and North Africa (MENA), the region witnessed significant growth in foreign direct investment in 2005. The inflow of FDI to the region increased to a record US$37.7 billion, which was 74% higher than last year. The relative share of MENA in total inflows of FDI into developing countries remains small, but it rose from 7.85% in 2004 to 11.24% in 2005. Within MENA, North Africa attracted US$12.7 billion, while the Asian part of the Middle East absorbed US$24.96 billion. The United Arab Emirates ranked first among Middle Eastern countries with FDI inflows of US$12 billion, followed by Egypt (US$5.37 billion) and Saudi Arabia (US$4.6 billion).

The high oil revenues of MENA oil-exporting countries have resulted in a large increase in intra-regional FDI outflows. Lebanon was the recipient of largest FDI inflows from other Arab countries. This large volume of investment underscored the continued input of Gulf countries in Lebanon despite that country's political and security woes. Saudi Arabia, in particular, stands out as a staunch economic and political supporter of Lebanon, testifying to its long-established business ties with the Hariri family of Lebanon. The flow of Arab FDI into Lebanon was disrupted in mid-2006 when Israel carried out a full-scale military assault against the Hizbollah militant group.

Iran’s ongoing standoff with the international community over its nuclear programme extracted a negative toll as it failed to attract more inflows than in previous years. The election of hardliner Mahmoud Ahmedinejad as Iranian president and his hostile international posture have created an added obstacle to foreign investment.

Africa—High Commodity Prices and Reforms Attract Investors

The phenomenon of rapid investment growth in sub-Saharan Africa has not been a direct result of low global interest rates. The low cost of borrowing does remain a lesser external factor, but strong commodity prices—as well as a friendlier regulatory environment—have been the driving force behind the upsurge in investment. FDI to the region rose to US$31 billion in 2005 from US$17 billion in 2004. The United Kingdom, EU, and United States continue to dominate FDI inflows to Africa, but Asia-Africa FDI flows rose significantly in 2005 and the nature of these inflows seems to be geared towards capacity-building activities. In 2005, the 47 greenfield investments from South, East, and South-East Asia accounted for more than 10% of all such investments in Africa. Of these, 16 were from China and 12 from India. By comparison, there were only 11 cross-border M&As from South, East, and South-East Asia.

North Africa, at US$13 billion, accounted for 42% of total inflows to Africa, driven by petroleum-industry investments in Egypt and privatisation in Egypt, Morocco and Tunisia. Sudan also attracted substantial FDI inflows from China, India, Kuwait, and Malaysia. Inflows to West Africa rose to US$4.5 billion in 2005. Nigeria accounted for 11% of the sub-regional total as investment dollars flowed to the hydrocarbon sector. Central Africa, with inflows of US$4.6 billion in 2005, accounted for 15% of Africa's total, concentrated mostly in the primary and tertiary sectors. Equatorial Guinea, the Democratic Republic of Congo, Chad, and Congo were major FDI destinations, with significant flows into infrastructure investment from China and South Africa. In East Africa, inflows totalled US$1.7 billion in 2005, down slightly from 2004. FDI activity has been driven by small transnational corporations (TNCs) from Egypt, South Africa, Mauritius, and Kenya investing in the region. Uganda attracted more than US$250 million in 2005. Inflows to South Africa rose sharply to US$7.1 billion. The acquisition of ABSA by an international banking group led by Barclays Bank contributed US$5 billion of the US$5.6-billion jump in FDI inflows. Minerals prospects and dormant mines throughout the region attracted FDI as a result of surging commodity prices.

On a sectoral basis, FDI inflows into the oil and gas sector were dominant, while manufacturing did not receive significant FDI inflows. Kenya, Lesotho, Mauritius, and Uganda saw FDI inflows rise under the African Growth and Opportunity Act (AGOA), and then fall as Multi-Fiber Arrangement (MFA) quotas were abolished in 2005. UNCTAD points out that most sub-Saharan African countries lack strong links between local enterprises (suppliers, presumably) and foreign TNCs and are therefore unable to realise economies of scale. UNCTAD observed 53 regulatory changes in Africa. Forty-two were favourable to FDI, while the other 11 were unfavourable. Angola, Algeria, Nigeria, Morocco, and Tunisia were cited among the countries targeting specific sectors for liberalisation. Mali and Ghana were cited as working to reduce barriers to FDI entry.

Prospects for growth in 2006 look good. Early estimates showed three times the number of cross-border M&As in the first half of 2006 when compared to the same period last year. TNCs from developing nations continue to invest in Africa's petroleum sector. South-south co-operation should continue to drive investment growth in Africa over the near term.

Outlook and Implications

The year 2005 was certainly a good one for FDI, and the slump that followed the market crashes of 2000 has come to an end. The outlook for 2006 is for further gains, thanks to the robust economic growth recorded by most of the major economies. Companies have continued to engage in strong M&A activity, their war chests flush thanks to the recovery of stock prices. Whether 2007 also registers further gains is less certain—growth has been moderating in the United States and rising interest rates in many countries could take the edge off companies' optimism. Geopolitical tensions, most notably in the Middle East and Asia, also feed the uncertainty.

UNCTAD warns in its report against government complacency. Policy choices are critical to investor decisions, and there are many countries where governments face protectionist temptations. The report finds that, on balance, regulatory trends were pro-FDI in 2005, including greater incentives, lower taxes and additional bilateral investment treaties (BITs), but in developed and developing countries alike there have been notable exceptions. In the United States, for example, there has been growing protectionist sentiment in the face of China's rapid economic advance and thanks to national security concerns, while in continental Europe many governments remain reluctant to see erstwhile "national champions" fall into foreign hands. In the developing world, Latin America has been notable for many countries' leftward political shifts and, in some cases, a more hostile environment for foreign investors.

Contact: Raul Dary

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raul.dary@globalinsight.com

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