Policy reforms need to address low financial returns which hamper the contribution of FDI to sustainable development. 

To many observers, multinational corporations seem to have considerable clout. Sophisticated global value chains criss-cross the planet and have an impact on numerous sectors of economic activity, the environment and labour markets. Consequently, governments and civil society have called on international business to make a more meaningful contribution to the advancement of sustainable development and the fight against climate change.

Some of these calls are motivated by concerns about business conduct, others by more practical considerations: governments have stated on record that they cannot finance and deliver on the Sustainable Development Goals (SDGs) without private sector involvement. Foreign direct investment (FDI) is an important source of capital for many economies, hence the question arises whether FDI is a viable channel for promoting the achievement of the SDGs and for mitigating climate change.

FDI inflows had already lost momentum well before the outbreak of the pandemic

The realities on the ground are chastening, as we evidence in the 27^th Global Trade Alert report. The decline in FDI outflows is alarming: once a hallmark of globalization, FDI has been struggling for quite some time, and is being further compounded by the ongoing pandemic. Even before the 42 per cent drop in FDI registered last year, sensibly benchmarked annual FDI inflows have been declining since the global financial crisis. Moreover, new greenfield investments in developing countries were hit particularly hard last year, plunging by 56 per cent year-on-year in the fourth quarter of 2020. As a result of the economic fallout from COVID-19, new FDI flows have retreated to levels not seen in 25 years.

The fact that FDI project approvals were put on hold last year is understandable. The fact that FDI inflows did not grow in line with the private sector’s overall capital expenditure even before the pandemic ought to be a cause for concern. If the contribution of FDI to sustainable development and the fight against climate change is dwindling, then any private sector contribution to these pressing global challenges must lie elsewhere.

Figure 1: Total private sector investment and world trade

Does FDI in emerging markets still pay off?

Doubts about the viability of new FDI flows into developing countries are growing. Using data reported by UNCTAD (based on balance of payments sources) and the United States we find that three things.

First, globally, the average return on FDI has declined over the past decade. Mean FDI returns decreased more in developing countries than in higher income countries. Second, with the exception of the Middle East, U.S. multinationals have earned, at most, meagre additional returns from FDI in developing countries since 2015, when compared with investments in less risky European Union economies.

Third, returns on U.S. FDI in educational services are so low that it would take 40 years to recoup their outlays. The payback period for investments in health and telecom is even worse at over 90 years (Figure 2). Higher returns from investment were reported for the manufacturing sector, while returns from the oil and gas extraction and the mining sectors were very low.

Figure 2: FDI returns in selected SDG-sensitive sectors

Falling returns on FDI are the canary in the coal mine – they call into question the commercial viability of setting up shop in developing countries and retaining operations there. Firms are not charities – in the absence of subsidies or other state-provided financial incentives, at the very least, FDI returns must exceed firms’ cost of capital. Over the past decade, however, FDI returns have been low by historical standards (partly on account of quantitative easing by central banks), but they are unlikely to be low enough to justify investment with decades-long payback periods.

To better visualize the effect of low financial returns on FDI, consider the following: bearing in mind that capital tends to depreciate by just under 4 per cent annually in developing countries (the median depreciation rate on capital for developing countries reported in the Penn World Tables is 3.9 per cent), fresh FDI inflows of at least USD 440 billion per year are needed just to maintain the current stock of FDI invested there. Whether international business is prepared to deploy such huge sums given the current business environment and policy mix is both an open and rarely asked question.