FDI: Is it really that difficult?

Today it's all about foreign direct investment (FDI).

Would it be really that difficult for Spain, Portugal and Greece to attract massive amounts of FDI as a way to build a strong industrial / export base and create stimulating and well-paid jobs (for their younger and well educated generations to start with) in a relative short period of time?

Ireland's example since the beginning of the 1990s gives a clear answer. The answer is "no":

- In the 1970's and 1980's, Ireland and Portugal had similar (low) levels of FDI as a percentage of GDP

- In 1992, Ireland started to consistently outperfom Portugal in terms of FDI. And in 1998 it started to play in a different league altogether: annual FDI amounted to an average of 15.1% of Irish GDP between 1998 and 2011. For Portugal the figure was 3.7%

One can always argue that Ireland is a much smaller country than Portugal, with a population of 4.5m vs. 10m for Portugal and that therefore its FDI numbers are biased to the upside. True in terms of population numbers. But not really relevant for this FDI analysis: the chart above doesn't show FDI per capita. It shows FDI per unit of GDP. And - surprise, surprise - Ireland's GDP is roughly the same size as Portugal's.

By the way, looking at the Portugal GDP / Ireland GDP ratio over time is very instructive:

- At the beginning of the 1970's Portugal's GDP was roughly 2.2 times larger than Ireland's. Normal, given the that the Portuguese population was roughly 2.6 times larger than the Irish

- From 1974 to 1984, the Portuguese GDP fell dramatically in relative size compared to Ireland's just to recover by the beginning of the 1990's. Actually, and contrary to first impressions, all normal here as well: following the Portuguese left-wing military revolution in 1974 that established democracy (it is not a typo, the revolution was led by the military. Was left-wing. And was peaceful - not a drop of blood was shed. Call it poetic if you want), the country entered a period of economic disruption and wave of nationalisations that culminated in two IMF interventions in 1978/79 and 1983-85. Good things, like democracy, don't come easy. And lunches are never for free. Joining the EU in 1985 brought back political and economic stability and by 1992 Portugal's GDP relative to Ireland's was not far away from its 1974 level.

- Abnormal is what happened next: from 1993 to 2007 Ireland overtook Portugal in terms of absolute GDP, despite having a population that was roughly 45% of the Portuguese in 2007. Ireland's relative rise started in 1993, picked up speed in 1995 and became definitely unstoppable in 1998. 1992 was the first year that Ireland started to consistently outperform Portugal in terms of FDI (measured as a percentage of GDP). 1995 the first year that saw the FDI gap widen significantly. And 1998 marked the point when Ireland's FDI performance left Portugal's decisively and consistently behind. Correlations. Causality. Does it ring a bell?

The difference in both countries current account performance since 1992 shows what a difference attracting FDI can make in terms of external imbalances:

- From 1992 on, Ireland's current account figures (measured as a percentage of GDP) were consistently 4% to 10% above the Portuguese.

- Even during the Irish real estate boom 2000-2008, when the Irish consumer spent (and imported) as if there was no tomorrow, the country's current account deficit hit 5.7% in its worst year vs. 12.6% for Portugal, 14.9% for Greece and 9.6% for Spain.

FDI not only allowed for a much faster economic growth of Ireland vs. Portugal as well as vs. Spain and Greece (4.6% annual growth 1992-2012 vs. 1.2%, 2.1% and 1.2%, respectively), but also for a much more externally balanced and therefore sustainable one.

Note: before you ask how comes then that the Irish net external debt (as a percentage of GDP) is nowadays not that far away from the Portuguese / Greek / Spanish one (92% vs. 107%/93%/92%, respectively) the answer is: Irish bank bail-outs in 2008-2010. To bail-out its banks the Irish government had to obtain external funding (from the EU / IMF), which is the main factor behind both the explosion in the country's public debt (from 11% in 2007 to 102% in 2012) and net external debt (from roughly 20% in 2007 to 92% in 2012).

Then again: the solid export base built via FDI over the past two decades, and nominal wage adjustment that took place over the past four years, has allowed Ireland to start to consistently post current account surpluses again since 2010. And a 4% annual current account surplus is expected for the coming six years (IMF data with the usual disclaimer "the risk of taking it at face value is all yours"). None of the other troubled Eurozone countries comes even close to the Irish performance.

An important note: FDI is broadly defined as the acquisition of an equity stake in a company by a non-resident with the aim of exerting long-lasting management influence (any equity stake of at least 10% qualifies). Therefore, FDI statistics include both acquisitions of at least 10% equity stakes in existing companies by non-residents (privatizations, takeovers) and the set-up of local subsidiaries by foreign entities (or the expansion of the production capacity of already existing local subsidiaries) - call the latter "expansionary FDI". It is this one that counts to build a strong industrial and export base.

So, the question of the day is: how can Spain / Portugal / Greece attract massive amounts of "expansionary FDI" and replicate (at least partially) the Irish model?

Start by focussing on three key areas:

1. A stable legal framework for FDI and an efficient judicial system, able to reliably and swiftly resolve any legal disputes that may arise over time.

2. No corporate tax on FDI in sectors defined as strategic for the first ten years. A reduced rate for all the others. No corporate taxes losses will occur as without these incentives FDI projects wouldn't be implemented anyway. Tax revenues will actually increase: the multinationals that move in will pay employers social security contributions and salaries on which income tax is due. On top of it, the network of local suppliers that will be build over time around the multinationals will pay corporate tax, employers social contributions and salaries on which employees will pay income tax.

3. Define which industries the country wants to build an industrial cluster in and realistically assess for which of them it actually has enough human capital to meet the demands of "expansionary FDI" projects. The ones for which a critical mass of human capital exists are the "strategic FDI sectors". Then identify which international companies from these sectors are absolutely wanted in the country and target them actively and relentlessly.

To do these "expansionary FDI" origination work a highly professional and concentrated promotional inward investment agency should be set up. Its offices should be located in strategic cities around the world; no more than 4-5 people per office, who should spent 3-4 days a week visiting the target "FDI companies" in their region and build a close relationship with their top management; the agency should also act as a one-stop shop for the multinationals that decided to invest in the country and accompany them throughout their entire set-up process. The motto being: "once you decide to invest in our country, for whatever problems you may face or support you need - just ring this number: we take care of everything". The agency officers should have a variable remuneration component dependent on the amount of FDI they were able to originate. 

Sounds too pro-active? For anyone who follows Chicago's school of economic thought to the core - "you don't need to change a burned out light-bulb. If it really needed to be changed, the market would have already done it" - it certainly is.

But guess what! There is a country that has had such an agency in place for many years (just don't know about the variable remuneration component). The country's name starts with an "I". And the investment agency is called IDA. The sectors defined long time ago as strategic are speciality chemicals / pharma / life sciences and IT services. Currently, speciality chemicals / pharma / life sciences account for 30% of the country's exports (25% of GDP); IT services for 20% (17% of GDP).

Dear Portuguese / Spanish / Greek authorities, Chicago is a place far, far away. Please change the light-bulb and switch the lights on.

Sprechen Sie Deutsch? Martin Wolf does not

Germany is truly Europe's great unknown. 

Everyone has an opinion about the country. Often a very strong one. Regarding Germany's EU crisis resolution strategy this is no different. And the dominant opinion goes like this: when it comes to economics, Germany is first class in practice. And third class in theory - Germans don't get it.

Right.

However, very few actually know what Germany is all about. With all sympathy, FT's Martin Wolf is not among them. His article in Wednesday's FT shows it once again http://www.ft.com/cms/s/0/aacd1be0-b637-11e2-93ba-00144feabdc0.html#axzz2SVLh5YuE

Contrary to what Martin Wolf writes, and many analysts claim, Germany never said that Eurozone's peripheral crisis was a fiscal crisis at inception (with the exception of Greece). Germany knows all too well that it was a private debt crisis. Just like everyone else does.

However, Germans also know - don't we all? - that the peripheral countries are plagued by structural problems that are at the origin of their lack of competitiveness , which led to the current crisis. The external imbalances are simply the expression of it.

What to do? Expansionary fiscal policies in Germany today and Eurobonds asap? Let's do the  numbers for the impact of a German expansionary policy in Spain:

- German imports from Spain were Eur 22bn in 2012, 2% of Spain's GDP. 

- Let's be optimistic and say that a fiscal expansion in Germany would lead to a 5% increase in its imports from Spain. This amounts to 0.1% of Spanish GDP. 

- Let's say that Spain's foreign trade multiplier is 2.5. This would lead to an increase of 0.25% in Spanish GDP. 

- Let's be optimistic and further assume that the fiscal expansion in Germany by having an impact in its imports from other countries, leading to an increase in their GDP, which in turn would lead to an increase in their Spanish imports set the Spanish foreign trade multiplier at 5. 

- The result would be an increase in Spanish GDP growth of 0.5% as a result of a German  fiscal expansionary policy. 

- A similar exercise could be run for Portugal (0.75% GDP growth) and Greece (0.25% GDP growth). 


All nice to have, but it wouldn't solve the EU periphery's underlying problems. If anything, it would only perpetuate them by delaying necessary reform implementation.


So, what's the alternative? What is Germany's implicit strategy? Keep the pressure high on the periphery, thus forcing / incentivising structural reforms that otherwise would never take place - well knowing that not all necessary reforms will be carried out to their full extent - and in this way create a very attractive environment for foreign direct investment (FDI). 

FDI is the most effective way to create the strong industrial basis the EU periphery is lacking over a relatively short period of time (5 to 10 years). And it will allow to reverse its chronic external debt / current account problem: it will have an immediate direct impact on the capital account. Once the FDI projects start to become operational they will generate a rise in exports, and allow for a sustainable and balanced current account at a higher level of imports (increase in imports driven by the rebound in internal demand once the economy starts to recover).

By how much will FDI have to increase in, e.g., Spain and Portugal to make this a successful and sustainable external re-balancing strategy? Make it 5% of GDP annually and we start talking business (note: acquisition of domestic assets by foreign investors, e.g. privatisations, don't count as FDI for the 5% target. A narrow FDI definition is being used: just the building of new production capacity by foreign investors qualifies as FDI): 

If we assume, conservatively, that FDI projects on average

a) have a 1.5x sales / capital employed ratio

b)  that all the capital employed comes from abroad

c) that 50% of the input factors have to be imported

d) that 90% of the production will be exported

we'll have a direct first-round increase in net exports accounting for 4.25% of GDP once the projects become operational. Implement an aggressive FDI strategy over a 10-year period and the peripheral countries' industrial landscape will look very different at the end of it.

In fact, current data shows the way: tourism, food, textiles / footwear account for only 40% of Spanish and Portuguese total exports. Not the 80%-90% that people tend intuitively to think. Where do the other 60% come from? Surprise, surprise: transportation equipment, electronics, high precision machinery, optical devices, chemicals/pharma. Do you know many Portuguese, Spanish companies from these sectors? No one does. The explanation is that multinational companies present in the countries are the main responsibles for these exports.
 
Conclusion: attract more of them. Make FDI bigger. Much bigger. And for this to happen do structural reforms conducive to an attractive FDI environment.

Will this be enough to eliminate the peripheral countries' legacy net external debt? No. Once the economic reforms are concluded or the social support for them has completely eroded (in 2-3 years time, the latest) a debt restructuring will have to take place. And top German officials are aware of this as well. But the debt restructuring should only take place then. Not now - as at least two very important reforms have barely started to be implemented: that of the overblown political-public administration apparatus (including subsidies to a diverse range of economic activities) and pensions (whose level is too high as they are based on salaries that were way above what the underlying level of productivity at the time justified).

Once you look at the numbers and think it through, the German strategy seems actually quite sensible. Only the illusion of short-term fixes for long-lasting structural problems can make anyone think otherwise. But short-term pain is, at times, the unavoidable price to pay for substantial long-term gain. For the EU peripheral countries, today is one of those times. They should seize the moment and don't let the crisis go waste.