MIGA (World Bank): During the Storm – Shift from North to South FDI

By Manabu Nose and Moritz Zander[1]

At MIGA (the Multilateral Investment Guarantee Agency) we see the principal near-term risks for emerging market foreign direct investment (FDI) on the supply-side of financing. Despite a rise of emerging market risk perceptions, demand for project financing continues to be strong. In the medium-run, intra-emerging market financing will increasingly replace funding from developed markets.

2011 was a tumultuous year for emerging market investors. First, there were the upheavals in the Middle East and North Africa region, widely known as the ‘Arab Spring.’ Waves of popular unrest led to regime change in Tunisia, Egypt and later Yemen. Libya and Syria got tipped into open civil conflict. Sub-Saharan Africa, while scoring some successes in democratic transitions, also signaled uncertainty with elections, a number of which were surrounded by violence, most notably in Cote d’Ivoire. Rising food and oil prices led to popular unrest in a number of regions. And more recently, investors were scared by military coups in places as diverse as Maldives and Mali, Papua New Guinea and Guinea-Bissau.

Yet, this resurgence of political risk in emerging markets contrasts with last year’s economic performance. Despite the slowing growth momentum in North America and the euro zone, developing countries’ aggregate growth, thus far, has proven impressively resilient. Not only did developing countries contribute much of global growth in 2011, but many countries managed to strengthen buffers against shocks through the oft-cited channels of trade and portfolio flows. Global foreign exchange reserves in emerging markets rose to over US$6 trillion by the end of 2011. And fiscal space in many places remains comforting, albeit less so than in 2008. If EU-based global corporates continued to post impressive earnings growth in 2011, it is because an increasing share of their revenues came from emerging markets.

Moreover, the above-average growth has not been confined to the traditional high-performers. Real growth in Sub-Saharan Africa (5.3%), for example, was robust, helped by booming commodity prices and exploration successes in mineral and petroleum sectors. Accordingly, investment opportunities in the emerging world, well beyond East Asia and Latin America, remain aplenty. Take sub-Saharan Africa. It is estimated that the continent needs over $90 billion dollars per year over the next decade to meet infrastructure needs: speak multi-million dollar investments in road and rail networks, power, water and sanitation projects, many of which will be solicited through public-private partnerships. In addition, the expansion of access to submarine fibers will create new opportunities in broadband and telecommunication service providers in still underserved markets.

On the face of it, we see the principal peril to emerging-market FDI flows on the supply-side of financing. For, critically, 2011 was a tumultuous year in advanced economies also. As concerns over sovereign debt sustainability, credit quality and market pressures in the European financial system intensified, bank lending in the euro area slowed markedly in the latter half of the year. Facing the prospect of stricter capitalization rules and pressure from regulators to improve buffers, many EU-based banks accelerated their efforts to deleverage.

The magnitude by which deleveraging in the European banking sector may detrimentally impact greenfield investment into emerging markets remains hard to predict. However, what we do know does not make us optimistic. Particularly in the euro zone, financing for projects and large bank syndication may become harder to come by in the longer run. Faced with higher dollar-funding costs and rules that require banks to match long-term loans with funding from sources with similar maturities, these business lines, in which European banks previously had a particularly strong position, will become less lucrative. Even in the petroleum sector, oil-secured lending—which is mainly dollar-based—could contract further as European banks see dollar-funding cost remain high.

Data presented in the IMF’s recent Global Financial Stability Report suggests that the bank deleveraging process in the EU will weigh particularly heavy on project finance and longer-term bank syndication. Across all emerging markets, bank lending in specialty lines such as project finance and structured credit fell sharply in the second half of 2011.[2] Similarly, while overall capital flows into emerging markets appear to have held up in 2011, syndicated bank lending to developing countries from EU banks has dropped sharply since last fall.

This is unfortunate because funding for projects in a number of developing countries is badly needed. For investors the prospect of permanently higher real growth sustained by improving buffers and more resilience remain. In preliminary data it appears that FDI flows into developing countries, albeit less volatile than portfolio flows, slowed considerably since the summer of 2011. But if emerging-market greenfield investment flows have not contracted further it is also because a growing share of those flows—what the World Bank calls “South-South” investment flows—is now originating in emerging economies.

Over the last two decades, emerging economies’ share of total outward FDI flows multiplied from 5% in 1990 to almost 30% in 2010. With slowing growth momentum in North America and the euro zone haunted by crises, there is every reason to believe that this trend will continue. In MIGA we have observed this shift both from our client base directly, as well as in our annual surveys of global investors.

Aside from strong balance sheets and a robust appetite to expand into yet untapped markets, what drives South-South investments? The fastest growing and lion’s share has come from Asia, notably China.  Historically, much of it has been resource-seeking FDI: extractive industries enterprises in resource-abundant Middle East, Central Asia, sub-Saharan Africa, and South America. More recently, however, the sector composition is diversifying. Manufacturing firms, including from the metal, electronics, and chemicals industries, have joined the pack, benefitting from lower unit labor costs.

Second, strong cash flows from the revenue of booming commodity prices have boosted cross-border merger and acquisition activity in the energy industry, originating in traditional oil-exporter countries around the Gulf region, Russia and the Commonwealth of Independent States (CIS). Prominent recent examples include the joint-venture between CNPC (China) and Russia’s Rosneft, or the participation of ONGC Videsh (India) in the development of the Sakhalin I oil and gas exploration project, also in Russia. Notably, outward FDI in the Arab states is mainly undertaken by state-owned enterprises such as Dubai World, the Qatar Investment Authority, and SABIC.

Finally, in Africa, the level of outward FDI is still limited, but intraregional investment (along with trade) is picking up fast. South African investors in particular are leading the way with respect to foreign investment into neighboring countries. Indeed, the potential for intra-Africa investment volume to further grow is large, as a recent UNCTAD report suggests, since South investors may be better positioned to develop business and manage risk in places that other foreign investors still perceive as impenetrable and excessively volatile.[3]

Research on the origins and drivers of South-South FDI is still limited, but explaining capital outflows from developing countries (where the marginal return to capital is higher) might be related to the ‘Lucas puzzle’ in international investment flows debated since 1990s. Access to resources is surely important, but it applies to only a limited number of countries such as China and some of the CIS. A competing hypothesis, more consistent with intraregional FDI in Africa, is risk appetite. South investors may simply be more comfortable with investing in developing countries, as they have a comparative advantage at operating in similar political, economic, and institutional environments as they encounter in their home markets. Related to the notion of familiarity (or Lucas’ information asymmetry) is a different conception of risk. For South investors, institutional quality may be less of a barrier to enter a new market, particularly if the tail risks of political events can be mitigated through insurance.

Surely, the sooner Europe’s banking sector will get fixed, the less the impact will be felt by developing countries. Nonetheless, over the medium term, the shift from North to South as the principal origin of emerging-market FDI flows will likely accelerate. For South-based investors with the right animal spirits and strong balance sheets may be better placed to capitalize on emerging-market momentum.