Globalisation has brought a surge in capital flows over the past four decades. Historically, the developed world has been the main exporter as well as beneficiary of these flows. However, as these markets mature, investors have looked elsewhere: the hunt for yield in the West’s increasingly zero-interest rate environment has only intensified the investment flow into emerging markets.
Policymakers in emerging markets have found it difficult to grapple with the potentially inflationary consequences of the sharp surge in “hot money” flows, but there is now more willingness to welcome foreign direct investment – FDI.
FDI inflows provide capital to boost the recipients’ development. This is especially important for countries with low savings rates. And FDI creates jobs in the recipient country and brings technical know-how and managerial expertise that can improve competitiveness. China’s success in achieving FDI-fuelled economic expansion over three decades demonstrates the allure of these flows.
But global FDI collapsed following the financial crisis, suggesting that its flows can be as volatile as portfolio investment. So will FDI remain weak if growth stays sub-par in the developed world? We don’t think so: investors will increasingly realise that the Western world’s slowdown is more structural than cyclical and that the emerging world will drive global growth over coming decades.
The search for alternatives will support the development of financial markets in emerging economies
So we expect the home bias of developed-world investors to be replaced increasingly by a search for better returns. After all, emerging markets are not only low-cost production hubs but also, increasingly, final demand destinations.
Outward FDI from the developed world into emerging markets is easy to explain – the hunt for cheap production and growing demand centres makes emerging countries attractive destinations.
However, outward FDI by developing countries is initially more puzzling. Shouldn’t undeveloped countries be trying to attract capital – plus technical know-how and managerial best practices – from abroad? Not necessarily: there are several reasons why enterprises in emerging markets look abroad to expand their businesses.
If outward FDI from Western countries was driven partly by the need to reduce production costs, for emerging markets, access to resources and expansion of trade are the primary drivers of investment abroad.
But there is now another compelling reason for emerging-market policymakers to encourage outward FDI. Emerging markets have been running massive current account surpluses, putting pressure on their currencies to appreciate. So far, these countries’ central banks have invested their currency reserves into very liquid assets such as G7 economies’ bonds. However, the financial crisis has shaken their confidence in Western financial assets so they are now looking to invest their earnings elsewhere.
The search for alternatives will support the development of financial markets in emerging economies. But a general wariness is also likely to fuel increased demand for assets over which investors have greater control or influence, implying a faster pick-up in FDI from developing countries.
We expect global growth will increasingly be driven by emerging markets. And as these economies develop, emerging markets will invest more heavily in each other. We expect outward investment from the BRIC economies – Brazil, Russia, India and China – to grow by USD1,200 billion by 2020, doubling the stock of outward FDI.
This research was first published on 3 July 2013.