Why FDI may not be as stable as governments think
| Author | Patricia Brukoff/Bjorn Rother |
| Position | IMF Policy Development and Review Department |
| Pages | 26-27 |
Page 26
Awidely shared view among academics and policymakers is that foreign direct investment (FDI) is a stabilizing factor during episodes of financial crisis in emerging market countries. Underlying this view is the notion that FDI is driven by positive longer-term sentiment about the recipient country and, to the extent that it entails physical investment in plant and equipment, is more difficult to reverse than other capital flows. On this basis, it is argued that policymakers should encourage such flows to "insure" against sudden reversals of capital flows.
Empirical evidence broadly supports the hypothesis that FDI flows are more stable than all other forms of capital. However, one should not be too quick to infer from aggregate data that the behavior of direct investment enterprises during crises is necessarily stabilizing from the perspective of the balance of payments. In particular, a narrow look at FDI flows risks providing only a partial perspective on the financing decisions of FDI enterprises.
Further improvements in the scope and coverage of FDI data and more analysis at the firm level are needed to better understand the behavior of direct investors and their host country affiliates in the context of a financial crisis.
Net FDI flows to emerging market countries increased dramatically in the 1990s, making direct investment the predominant source of private external financing for this country group. Moreover, the positive trend prevailed, notwithstanding several financial crises in emerging markets during 1990-2005 (see chart). Indeed, annual net FDI flows to emerging market countries-both in U.S. dollar terms and as a share of recipient countries' GDP-have remained consistently positive throughout the period and increased steadily, except in 2002-03, when flows to Latin America declined temporarily in the wake of the crisis in Argentina. In contrast, net portfolio investment and other investment registered substantial net outflows from emerging markets during some of the years under review.
A closer look at selected episodes of financial distress at the country level generally reinforces the view that FDI flows are stabilizing. In particular, FDI is typically more stable than portfolio and other investment flows when the volatility of the respective flows is scaled by their mean size (see table). The data also...
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