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Kim Zu-Kweon

Global Financial Crisis, FDI and the Role of Government Policy

Kim Zu-Kweon

June 5, 2009

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Foreign direct investment (FDI), which represents companies' business activities in foreign countries, reached a record US$1.9 trillion in 2007. World economic growth, liberalization, deregulation and the internationalization strategies by multinational enterprises (MNEs) since 2003 were the major impetuses to setting the record level. However, the global financial crisis originating in the US placed a cloud over the upward trend and dragged down FDI to US$1.6 trillion in 2008.

The impact of the global financial crisis on developed countries has been more significant. While FDI inflows into developing countries increased by 7.2% between 2007 and 2008, those into developed countries decreased by 25.3% in the same time period. There has been extreme shrinkage in FDI flows directed toward financial services, automobile industries, and other consumer products because of diminished global demand. In contrast, more FDIs have moved into new growth engine industries such as renewable energies, resource, and environment-related industries.

The financial crisis could have both positive and negative impact on global FDI prospects. Lower asset prices and industry restructuring stemming from the crisis may create new investment opportunities among rich MNEs, especially those from developing countries. Newly growing industries, called new growth engine industries, will attract more FDI rather than other industries that are loosing their attractiveness because of dented global demand. In addition, governments' emergency measures will help boost FDI. However, positive consequences from the crisis could be overwhelmed by negative effects. Reduced corporate profit and tightened credit conditions triggered by the crisis constrain firms' ability to invest. Also, increased uncertainties in global markets incite firms to implement more risk-adverse strategies such as divestments, retrenchment finance, or cancellation of international investment projects.

United Nations Conference on Trade and Development (UNCTAD) forecasts that global FDI will be in decline over the next two or three years. UNCTAD's projections on FDI are based on three scenarios and emphasize the role of government in each case. The first one is a V-shaped scenario, which is the most optimistic. This scenario expects that FDI will continue its slide in the second half of 2009 but then bounce back quickly. "U" scenario is the next which anticipates gradual recovery will start in 2011. The last one is "L" which is the most pessimistic. This scenario prospects that the downward trend will continue until 2012. UNCTAD also forecast that the trend of global FDI will be determined according to the efficiency of government policies, the depth and length of global recession, and the recovery speed of investors' confidence.

One of the critical government policies that can hamper global FDI is protectionism. In previous recessions, governments deregulated FDI measures in order to recapitalize domestic firms or to improve the balance of payment. However, at this time many governments are initiating many FDI restrictions and justifying them as needed steps for national security, raising tax revenue and fair competition. For example, on May 4, 2009 the Obama administration announced a tax reform titled "Leveling the Playing Field." Its main thrust is to remove tax breaks for U.S. firms that invest overseas. The measure is part of a package of international tax reforms that the Obama administration predicts will raise US$210 billion over the next 10 years and create more jobs domestically.

However, many economic interest groups assert that the reform ignores the contribution of US MNEs to the American economy and impair their competitiveness in global markets. This kind of protectionist measure will encourage retaliation measures by governments and lead to further shrinkage in FDI.

Considering the reduction of FDI and protectionist measures, not only will there be more competition to attract FDI, but also any dramatic increase in global FDI will not be expected in two or three years.

Therefore, the right role of policymakers to conquer the current financial crisis and to increase FDI is to overcome the temptation of protectionism as well as to create more investment-friendly environments. A good example of protectionism is "beggar-thy-neighbor" policies, which advance the interests of nations at the expense of fellow nations. As seen during the Great Depression of the 1930s, government policies aimed at trade balance, inflation, and unemployment hampered trading partners by imposing import restrictions and devaluation of a currency. The policies did not cause the depression, but were a major factor in deepening and prolonging it.

In addition, governments' emergency measures during the current crisis should be implemented temporarily and transparently with an exit strategy that removes government assistance when economies are back to the normal to ensure fair competition on the global level.

The writer is a visiting research fellow at Samsung Economic Research Institute.

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