Forecasting foreign investment in China, Japan and India

Friday, September 7, 2007

Asia’s three giants—China, Japan and India—all acknowledge the importance of attracting foreign direct investment (FDI), yet their fortunes in this sphere will vary widely between now and 2011, according to a new report. FDI has become an inextricable part of the Chinese economic success story and this is likely to continue. Japan, a belated convert to the merits of FDI, will struggle to quickly improve its poor performance in this sphere. India, which often ranks second only to China in the minds of emerging-market investors, will chart a mid-course: FDI will rise, but the country will continue punching below its weight.

The report—World Investment Prospects to 2011: Foreign direct investment and the challenge of political risk—produced by the Economist Intelligence Unit (EIU) in co-operation with the Columbia Program on International Investment (CPII), charts global FDI trends over the next five years, including on the basis of a global survey of more than 600 direct investors. Within this global survey, the Asian giants—together accounting for nearly 30% of global GDP measured at purchasing power parities—loom large.

Whereas China’s and Japan’s contrasting medium-term FDI profiles look reasonably clear, considerable uncertainty surrounds India. There are widespread expectations of a major surge of FDI inflows. However, the EIU-CPII report argues that despite the country’s dynamism and increasing global economic importance, inflows to India are likely to remain relatively modest, certainly in relation to the country’s potential.

China out front

With projected inflows of some US$87bn per year in 2007-11 China is expected to rank third globally, behind the US and UK. China’s projected share of global FDI inflows of some 6% in 2007-11 would be equal to its share in 2002-06. China continues to be ranked by most international firms as their preferred investment destination, including in the survey conducted for World Investment Prospects.

Despite some signs of the incipient FDI protectionism that is also affecting many other parts of the world, the dominant trend in China is likely to remain one of FDI liberalisation. China is committed to meeting its World Trade Organisation (WTO) obligations. The gradual opening up of domestic commerce, financial services and tourism is under way. Geographical restrictions on where foreign companies are allowed to set up operations will also be relaxed in the coming years. China’s price competitiveness will be maintained over the forecast period. On baseline assumptions, there seems little risk of a massive relocation of FDI from China to cheaper locations.

Still Japan Inc

As the world’s second-largest economy (at market exchange rates) and boasting one of the world’s largest consumer markets (with a wealthy population of nearly 130m), Japan should, in theory, offer inward investors ample rewards. The reality is rather different. The rate of FDI penetration as measured by the share of the stock of inward FDI in GDP, at 2.5%, is one of the lowest in the world. FDI inflows into Japan fell by more than half in 2005, to US$3.2bn (a mere 0.1% of GDP, one of the lowest ratios in the world) from what was a modest average of US$7.3bn in 2001-04. Large disinvestments meant that inward FDI flows turned negative in 2006, at US$-6.8bn.

Officially, the Japanese government now welcomes inward FDI. In practice, however, Japan’s FDI regime remains difficult, owing to the complex regulatory environment that appears designed to protect domestic players. High labour costs, weak growth in recent years and cultural barriers also help to explain the low FDI levels. Although some pick-up is expected during the forecast period, FDI inflows will remain very low as a share of GDP and the ratio of the stock of inward FDI to GDP is projected to rise to only 3% by 2011. Japan will remain a difficult country in which to invest and change is likely to be incremental at best.

India to disappoint

FDI inflows into India grew strongly to US$17.5bn in 2006, two and half times the US$6.7bn recorded in 2005 (although some US$4.6bn of the 2006 recorded inflow was owing to two accounting transactions which resulted in an FDI inflow and outflow of the same amounts).

Despite strong growth in FDI inflows in 2005-06, India has yet to build a critical mass in FDI. Despite India’s successful positioning as a business processing and IT outsourcing hub, these activities are accompanied by relatively little FDI . The services sector continues to be the main target for FDI in India. By contrast, FDI in manufacturing actually declined in 2006 to US$1.5bn, compared with US$1.8bn in 2005, reflecting the fact that the environment for manufacturing FDI is not yet attractive enough. FDI inflows into India are set to grow further over the medium term, but will remain well below potential because of continuing political resistance to privatisations, inflexible labour laws and poor infrastructure.