Fragmenting Foreign Direct Investment Hits Emerging Economies Hardest

IMF Blog, April 5, 2023

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Long-term global output losses from geoeconomic fragmentation are close to 2 percent of world gross domestic product.
Emerging market and developing economies are particularly affected by reduced access to investment from advanced economies, through reduced capital formation and productivity gains from technology and know-how transfer.
Over the last decade, the share of FDI flows among geopolitically aligned economies has kept rising, more than the share for countries that are closer geographically, indicating geopolitical preferences increasingly drive the geographic footprint of FDI.
The flow of strategic FDI to Asian countries started to decline in 2019 and has recovered only mildly in recent quarters; flows to China have not yet recovered.

Geoeconomic fragmentation trends are driven by policy shifts such as friend-shoring, the Net Zero Industry Act proposal, and efforts to replace imported technology with local alternatives.
Strategic sectors, like semiconductors, show pronounced divergence in FDI patterns across host countries.
Rising geopolitical tensions are associated with increased concentration of FDI within blocs of aligned countries.

An index of countries’ exposure to FDI relocation shows emerging market and developing economies are more vulnerable to FDI relocation than advanced economies, in part because they rely more on flows from more geopolitically distant countries.
Several large emerging economies are vulnerable to the relocation of FDI; vulnerabilities are not concentrated in a few countries.
Advanced economies are not immune, particularly those with significant FDI stocks in strategic sectors.
Vulnerabilities can extend to non-FDI flows and could trigger a large reallocation of capital flows at the global level.

Reshoring or friend-shoring can strengthen national security and help maintain technological advantages but often reduce diversification and increase vulnerability to macroeconomic shocks.
Relocating FDI closer to source countries could hurt host economies through reduced access to capital and technological advances.
Entry of multinational corporations often benefits domestic firms:
- In advanced economies, increased competition from foreign firms spurs domestic enterprises to be more productive.
- In emerging market and developing economies, domestic suppliers benefit from technology transfers and increased local demand for components used in downstream industries.
Vertical FDI—where foreign companies enter a country to produce inputs supplied to affiliated firms—is concentrated among intermediate-goods producers that deploy more sophisticated and skill-intensive technology (example noted: Samsung Electronics semiconductor factory in Vietnam supplying mainly to other units of the Korean conglomerate).

A fragmented world is likely to be a poorer one, with estimated long-term global output losses close to 2 percent of world GDP.
Losses are unevenly distributed; emerging market and developing economies suffer more from reduced capital formation and lost productivity gains.
Some economies could gain from redirected investment (for example, economies remaining open to different geopolitical blocs), but such gains are uncertain and could be offset by spillovers from weaker external demand and uncertainty about future alignment choices.

Policymakers should carefully balance strategic motivations for reshoring and friend-shoring against domestic economic costs and cross-border spillovers.
The current rules-based multilateral system must adapt to the changing world economy and be complemented by credible mechanisms to mitigate spillovers from unilateral policy actions.
Multilateral actions should minimize policy uncertainty, including by improving information sharing through multilateral dialogue.
Developing a framework for international consultations—for example, on the use of subsidies that incentivize reshoring or friend-shoring of FDI—could help governments identify unintended consequences, mitigate cross-border spillovers, reduce uncertainty, and promote transparency on policy options.

—This blog is based on Chapter 4 of the April 2023 World Economic Outlook: “Geoeconomic Fragmentation and Foreign Direct Investment.”