FDI flows into the countries stricken by the financial crisis in Asia in the second half of 1997 have been resilient in the face of the crisis, remaining positive, and continuing to add to the capital stock of the affected countries. Inflows last year to the five Asian economies most affected by the financial crisis -- Indonesia, Malaysia, Philippines, Republic of Korea and Thailand -- remained at a level almost unchanged from that in 1996. In contrast, bank lending and portfolio equity investment fell sharply, and turned negative in 1997 as a whole. East and South-East Asia saw a small increase in foreign direct investment (FDI) in 1997.
There is room for cautious optimism as regards FDI inflows into the five most affected countries as a group and for the region as a whole for 1998, even though flows may not return to their 1996/1997 level. These are the main findings of a new assessment from UNCTAD released today of the impact of the financial crisis in Asia on FDI flows to and from the region(1).
Although outward FDI from the five most affected countries increased somewhat in 1997, it is expected to decrease substantially in 1998. This may affect especially Asian developing countries, as a number of these receive nearly half of their FDI from other Asian developing countries. FDI flows into other regions -- Africa, Latin America, Central and Eastern Europe, the United States, Japan and Western Europe -- will remain largely unaffected by the decrease of FDI outflows from Asia because FDI inflows originating in Asia typically account for less than 2 per cent of total inflows into other regions.
Inward FDI to the most affected countries: a transformed scenario
The crisis and its economic aftermath have changed a number of factors that influence FDI and transnational corporation (TNC) operations in the affected countries, at least in the short and medium term. Some are conducive to increasing FDI flows to the affected countries:
- First, the dollar costs for foreign investors of expanding in the most affected countries -- be it through greenfield investments, the expansion of existing investments or mergers and acquisitions (M&As) -- have decreased, because asset prices have fallen and because of devaluations. In addition, a number of local firms are disposing of assets to obtain finance.
- Second, improvements in the international cost competitiveness of production in the affected countries due to devaluations has made these countries more attractive as sites for export-oriented investments.
- Third, the liberalization of government policy with respect to inward FDI has made FDI by foreign investors easier.
For TNCs that take a long-term view of the market prospects in the region, as well as TNCs that produce for export rather than for domestic or regional markets, these three factors are serving to encourage FDI. Promotional efforts by the five affected countries further facilitate inward FDI in response to these factors. Firms from the United States, Western Europe and the less affected economies in the region have taken the opportunity to invest, including through M&As, in the crisis-affected Asian countries. Thailand and the Republic of Korea have benefited particularly in this regard. However, growing concerns about the possibility of loss of national control over enterprises must also be taken into account. In some countries, hostile takeovers in particular are viewed with suspicion by the public. Sensitivities in this respect must be appreciated, UNCTAD says, as otherwise the prospects for a long-term partnership between foreign investors and host countries through FDI could be adversely affected.
Other consequences of the crisis, on the other hand, are affecting FDI adversely. Reduced domestic demand and slower economic growth have lead to some cancelling, scaling down or postponement of FDI in the most affected countries by firms focused on domestic or regional markets.
The impact on domestically-oriented foreign affiliates varies among industries, as the results of a survey of affiliates of foreign firms in the Republic of Korea by UNCTAD and the Federation of Korean Industries in March-April 1998 show. Foreign affiliates in the services sector are particularly susceptible to changes in local demand, because of the non-tradability of most services. And, affiliates producing goods and services that depend mainly on imported raw materials and intermediate inputs, and serve mainly domestic markets, are more seriously affected than those relying on domestic sources.
The automotive industry, in which TNCs figure prominently in the region, provides a good example of the impact of the crisis and the broad range of responses to it so far. A number of automotive TNCs have scaled down, postponed or even cancelled investment projects in some of these countries. However, some firms in the automotive as well as other industries have adopted measures to cope with the crisis, including injecting funds to help their financially distressed affiliates and subcontractors, relocating parts production, boosting exports and increasing domestic sourcing.
The overall impact of these conflicting influences on the size of FDI flows to the affected countries is difficult to predict. But data for the first quarter of 1998 suggest that, for the five countries taken together, inflows in 1998 may not reach the level of 1996/1997.
Behaviour of Asian TNCs significantly changed by crisis
Outward FDI by TNCs headquartered in developing Asia increased substantially in recent years. For the major Asian developing home economies taken together, the stock of FDI located in other developing Asian economies was at least one-half of their total outward FDI. However, the financial crisis is likely to curtail both the capacities of, and incentives for, Asian TNCs to undertake outward FDI. The financial strength of the region’s TNCs has been weakened by the fall in the book value of the assets of firms. This is due to the drastic currency devaluations and sharp falls in stock prices that have taken place; the heavier burden of servicing debt denominated in dollars, especially for those Asian TNCs with high debt-equity ratios and those with foreign affiliates oriented to local markets; and by reduced earnings, due to the decline in demand in crisis-affected host countries.
The ability of Asian firms to invest abroad has been further constrained by high interest rates and, in some cases, a general credit crunch at home; the increased cost of foreign operations due to the depreciation of domestic currencies; and by the difficulty of raising funds abroad due to lowered credit ratings. In fact, a shortage of cash has induced a number of Asian firms to divest assets abroad, especially in Asia, Europe and the United States, to raise funds for working capital.
In addition, the crisis has changed some of the parameters that had induced Asian firms to invest in other parts of Asia, further weakening outflows. Although they have the possibility to switch to unaffected countries, decreased economic growth and demand levels in some Asian countries reduce the incentive for market-seeking TNCs from Asian developing countries to invest or reinvest in those countries. Moreover, efficiency-seeking TNCs headquartered in home countries whose currencies have been significantly devalued may find that the devaluations in Asian countries have reduced the cost differentials between producing at home and producing abroad by so much that it is no longer worthwhile for them to move labour-intensive production abroad in order to be competitive in world markets. Furthermore, restrictions on outflows of capital imposed by governments to deal with the crisis could also discourage outward FDI. In brief, the incentive for Asian TNCs to invest in Asia -- by far their main host region -- has been weakened, at least in the short-to-medium term.
In 1997, outward FDI from four of the five most affected countries had already decreased (and there was a substantial decrease in cross-border M&As over the second half of 1997), even though outflows had been somewhat higher than in 1996. In 1998, FDI outflows from developing Asia in general, and from the five most affected countries in particular, can be expected to decrease substantially, and outward FDI can be expected to remain low for some time to come. First quarter data for the Republic of Korea and Malaysia are indicative of this. Moreover, two-thirds of 46 large TNCs based in the Republic of Korea who responded to an UNCTAD/Federation of Korean Industries survey in March-April 1998 indicated that they had either cancelled, scaled down or postponed their investment plans. This applied to both manufacturing and non-manufacturing firms. According to the survey, Korean firms expect to invest less in virtually every one of their major investment destinations in 1998-1999.
In the less affected major home economies of Asia (China, Hong Kong (China), Singapore and Taiwan Province of China) the picture is somewhat different. Their outward FDI increased slightly in 1997 over 1996, indicating that, at least until last year, a combination of their financial strengths and economic reasons for doing so favoured continued investment abroad. Total M&A purchases outside Asia by firms from the less-affected major outward-investing Asian economies increased in 1997 over 1996. Whether this will continue in 1998 is uncertain.
In the longer term, it can be expected that outward FDI from the region (including the crisis-affected economies) will resume its upward trend, because the fundamental determinants of Asian outward FDI -- such as marketing and management knowhow, and accumulated technological capacity, especially in medium-technology industries and in adapting technology to the needs of developing economies -- can be expected to reassert themselves once the present difficulties have been overcome.
FDI to less affected Asian countries: disruption of the "flying geese" paradigm
To the extent that FDI flows into developing countries in Asia less affected by the crisis decline, the interactive TNC-assisted restructuring that has been one of the dynamic forces in Asian development, within the framework of the celebrated "flying-geese" pattern, could slow down or be interrupted.
The most pertinent factors include: the reduced capacity of TNCs in the region to invest abroad; the possibility of reduced growth in the less affected countries in the region, making them less attractive as destinations for market-seeking FDI; and the reduced competitiveness of exports from the less affected countries, resulting from the devaluations in the most affected countries.
Countries in which these factors come into play are likely to experience a fall in FDI. In particular, FDI flows into countries that receive significant amounts of investment from within the region -- especially coming from the five most affected countries -- could fall. These are mainly China, Viet Nam, most of the Asian least developed countries (Bangladesh, Cambodia, Lao People’s Democratic Republic, Myanmar) and Central Asia. The same considerations could also influence FDI flows from developed countries to the less affected Asian developing countries.
Little effects on FDI into other regions
Countries in other regions -- Africa, Latin America and the Caribbean, Central and Eastern Europe and the developed countries -- are unlikely to be affected by a direct decline of FDI outflows from Asia (including from the five most affected economies), UNCTAD says, because the share of developing Asian economies in their total FDI inflows is very low -- typically less than two per cent.
Could some TNCs find sites in other regions more attractive relative to those in Asia for new investment projects?
The ability of investors to substitute actual or potential FDI in one host region (or country) with FDI in another depends largely on the type of FDI, as well as on the sector or industry concerned. For instance, natural-resource-seeking FDI is largely location-specific and substitution is likely to be limited. Asset-seeking FDI may even be attracted to Asia by the new opportunities arising in the aftermath of the crisis. Efficiency-seeking FDI may also be attracted by falling costs in Asia. And market-seeking FDI depends mainly on the size and income growth of host countries. Thus, while the contraction of markets in the affected countries in Asia is likely to reduce some market-seeking FDI in the short-to-medium term, this does not necessarily mean a switch to other regions. Since FDI is not a zero-sum game, it need not be assumed that FDI into other regions must involve some withdrawal from Asia, UNCTAD believes. Overall, the extent of a shift of FDI from the crisis-affected countries to other regions is thus likely to be limited.
A brighter light at the end of the tunnel?
Despite their overall resilience during 1997, FDI flows to the five most affected countries as a group and to the region as a whole are likely to fall somewhat in 1998. Beyond that, much depends on the global economic environment as well as the extent to which the financial crisis spills over into the real sector affecting GDP, income and employment growth. Aside from that, given that the basic FDI determinants -- regulatory frameworks, the business environment and, most importantly, economic determinants of long-term growth -- remain attractive, and that the changes resulting from the crisis have positive as well as negative implications for FDI, there is room for cautious optimism.
The extent to which these various factors translate into actual FDI flows will depend on the assessment by TNCs of the long-term prospects of the region, in the context of their own strategies for enhancing competitiveness. If these assessments are negative, TNCs will be reluctant to invest, especially as far as market-seeking FDI is concerned, and will be cautious in acquiring assets in the region. If they take a positive view, however, and take advantage of the crisis to position themselves strategically in the region, FDI flows to Asia could continue after 1998 on their previous upward trend, without serious interruption. This judgement is based on the premise that the fundamental features of the region as a destination for FDI remain sound. As the February-March 1998 UNCTAD/ICC survey showed, TNCs rate highly the long-term prospects of the region as an investment destination. Not only do longer-term FDI prospects for the region remain positive, but they may even improve as the affected countries strengthen aspects of their economies in response to the crisis.
