Inward FDI Attraction

Is Canada attracting its “fair” share of inward FDI?

HCP 2011 Inward FDI video still

Key Messages

  • Canada’s share of global inward foreign direct investment (FDI) has dropped significantly over the past few decades, but Canada still attracts slightly more than its “fair” share of FDI.
  • In this new era of integrative trade, global supply chains are driven by FDI.
  • To attract FDI, Canada should focus on creating a business environment that is more open to competition and conducive to innovation—especially in key industries such as telecom and air transportation.

How has Canada’s share of global inward FDI changed over the years?

Canada’s share of global inward foreign direct investment (FDI) flows dropped from 16 per cent in 1970 to 3 per cent in 2009.1 The U.S. share rose from 8 per cent in 1970 to 29 per cent in 1986 before falling to 12 per cent in 2009. Other developed countries (excluding the U.S. and Canada) experienced a small decline—from 51 per cent of world FDI inflows in 1970 to 45 per cent in 2009.

Which countries increased their share of global FDI inflows?

China’s share of global inward FDI flows grew from almost 0 in 1970 to 11 per cent in 2009.2 India’s share increased as well, but not nearly as spectacularly. Other developing economies (excluding China and India) draw a lower share of global inward FDI, but this share has been increasing steadily, albeit slowly, over the past decade.

Is a declining share of global inward FDI inevitable for developed countries?

No. Perhaps surprisingly, the European Union’s share of global inward FDI has been fairly stable. After dipping in the early 1980s, the EU’s share has now almost regained its 1970 peak of 42 per cent.

Is Canada losing its “fair” share of global inward FDI?

The addition of the word “fair” in the question completely changes its intention. We have already established that Canada has lost a significant share of global inward FDI. But is that loss justifiable? Perhaps the drop in FDI share simply reflects the fact that Canada is becoming a smaller global economic player overall.

To answer this question, we need to compare a country’s share of global FDI with its share of global gross domestic product (GDP). This ratio is called the inward FDI performance index. The inward FDI performance index captures a country’s relative success in attracting global FDI. If a country’s share of global inward FDI matches its relative share of global GDP, the country’s inward FDI performance index is equal to 1. A value greater than 1 means the country is attracting more inward FDI than its economic size would warrant. A value of less than 1 indicates it is attracting less inward FDI than it should, based on the size of its economy.

The inward FDI performance index results tell a slightly different story than simply using the share of inward global FDI.3 Yes, Canada’s index dropped significantly between 1970 and the mid-1990s. The high index number in 1970—6—meant that Canada was attracting six times more inward FDI than its economic size (GDP) would warrant. Since 1995, it has hovered in the 1.1 to 1.2 range. But the fact that Canada’s index is greater than 1 means that its share of global inward FDI is still larger than its share of global GDP. While the ratio is not significantly greater than 1, the fact that it is higher than 1 means that it is not correct to say that Canada is not attracting its “fair” share of inward FDI.

The U.S. has an inward FDI performance index that is less than 1, meaning that is it not attracting its “fair” share of inward FDI. Other developed countries (excluding Canada and the U.S.) saw a decline in their combined inward FDI performance index in the 1970s, but it has since stabilized around 1.

China’s inward FDI performance index tells an interesting story. China’s index reached 1 in 1979 and then rose quickly to peak at 2.8 in 1994. This was a period of huge international investment in China. As the investment began to have a positive impact on China’s economy, the country’s economic growth also began to rise quickly, and China began to account for a larger share of global GDP. This resulted in the ratio of its FDI share to its GDP share falling somewhat. China’s inward FDI performance index is still above 1, however, meaning it is attracting more inward FDI than its economic size warrants.

India’s inward FDI performance index, while still below one, has been increasing steadily and looks set to move above 1. Other developing countries (excluding China and India) attracted more than their “fair” share in the 1980s and 1990s, but their inward FDI performance index dropped below one in 2001.

Use the bubble diagram below to see how the relationship between shares of world GDP, shares of world FDI, and inward FDI performances indexes have changed over time for Canada and its peer countries. Follow these steps:

    1. Under “Color,” choose “Country.” That way, each colour will represent a specific country. (When you scroll over each different coloured bubble, the country name will pop up.)
    2. Under “Size,” choose “Share of World GDP” as the variable that determines the size of the bubble. That way, you will be able to see at a glance how countries with a larger share of world GDP are doing compared with those with a smaller share.
    3. Choose “Inward FDI Performance Index” as the variable to track on the horizontal axis.
    4. Choose “Share of World FDI” as the variable to track on the vertical axis.
    5. If you want to see a trail for a particular country, click in the “Trails” box, and then click in the box of the country (or countries) you want to trail. Each country will be represented by a trail of bubbles in its unique colour.
    6. Finally, click the play button in the bottom left to begin the show.

      An interesting example is to choose Canada, China, and the U.S. in the trail box (step number 5). You will see that Canada’s share of global inward FDI falls continually, while that of China increases. At the same time, Canada’s inward FDI performance index falls and then stabilizes, while China’s rises and then falls. The U.S. share of world FDI rises then falls, but its performance index remains fairly steady and below 1. The sizes of the U.S. and Canadian bubbles don’t change much, meaning that their share of global GDP has been fairly constant, but China’s bubble increases in size, reflecting the fact that China now accounts for a relatively larger share of global economic output.

      You can track the history of the same indicators over time for country groupings (developed economies, developing economies, G8 economies, etc.) in the second bubble diagram. The indicator names have been abbreviated in the bubble diagram for ease of use:

      • D’ed—refers to developed economies
      • D’ing—refers to developing economies
      • Mfg Exp: D’ing—refers to major manufactured goods exporters in developing economies
      • Mfg Exp: D’ing Asia—refers refers to major manufactured goods exporters in developing Asian economies
      • Oil—refers to major petroleum exporters in developing economies

      An interesting result to watch is the rise of investment in manufacturing exporters compared with that of petroleum producers.

      Why is inward FDI so important?

      Inward FDI helps expand trade. It can also boost productivity by providing access to new technology, business and manufacturing processes, and management know-how, as well as by fostering a competitive and innovative business environment.

      For some time now, the Conference Board has argued that one of the causes of Canada’s slipping economic performance relative to its peers and to emerging economies is insufficient inward FDI. In this new era of integrative trade, global supply chains are driven by FDI. Between 1990 and 2007, global GDP increased by an average of 5.5 per cent per year and exports by 8.5 per cent; the flow of FDI worldwide grew by a whopping 14.6 per cent per year.

      Is there a relationship between inward FDI and labour productivity?

      Many factors affect labour productivity—a couple of key ones being investment in machinery and equipment (M&E) and the education and skills of the labour force. But what about the impact of inward FDI on labour productivity? Is there a positive relationship between inward FDI stock as a share of GDP and labour productivity?

      We investigated this relationship for Canada and its 16 peer countries over the past three decades. A time-series regression (fixed-effects panel analysis) using data for the peer countries from 1980 to 2009 revealed a positive relationship (with a correlation coefficient, or R2, or 0.74) between the natural log values of labour productivity and inward FDI stock as a share of GDP.

      The scatter charts show the positive relationship between labour productivity and inward FDI stock over a shorter time period (a five-year average from 2005 to 2009). Two countries stand out as exceptions: the U.S. and Norway. The first chart reveals that there is not a strong relationship in the U.S. and Norway between inward FDI and labour productivity—both countries have much higher labour productivity than would be predicted by their level of inward FDI stock. One reason for this may be that although FDI as a share of GDP in the U.S. is relatively low, its share of global FDI stock is the highest among the 17 peer countries. In addition, increased investment in M&E, particularly ICT, has been a great contributor to labour productivity growth in the United States.4

      Norway has the highest labour productivity, yet a relatively low proportion of inward FDI stock—both as a share of GDP and as a share of world inward FDI. Norway also ranks low on M&E investment. So why is Norway’s labour productivity so high? Norway has high GDP thanks to its oil and gas industry. The industry is also capital-intensive, which means that labour productivity in that industry is high. As well, the ratio of average annual hours worked per person employed in Norway is among the lowest in the OECD—hence GDP per hour worked is high.

      The correlation between inward FDI stock as a share of GDP and labour productivity is much stronger when we exclude the outliers, Norway and the U.S., from the analysis, as seen in the second chart.

      The bubble diagram below is set up to track the history of inward FDI stock and labour productivity for the 17 peer countries. The size of the bubble represents the share of global inward FDI stock. Many of the countries that have a high FDI stock as a share of GDP also have high labour productivity. In fact, since 1980, Denmark, France, Sweden, and the U.K. have all moved ahead of Canada on inward FDI as a share of GDP and on labour productivity. Canada’s inward FDI stock as a share of world inward FDI has declined over the years—as shown by the shrinking bubble. Canada’s inward FDI stock as a share of GDP has increased in recent years thanks to the commodity boom in the mid-2000s that sparked a wave of investments in Canada’s resource industries—particularly the mining and energy sectors. But despite the increase in inward FDI stock as a share of GDP, Canada’s relative ranking on this indicator has fallen. In 1980, Canada ranked 2nd among 15 peer countries for which data on inward FDI stock as a share of GDP were available. By 2009, Canada had slipped to 9th among the same 15 peer countries.

       

      What affects the relationship between inward FDI and labour productivity?

      OECD research has shown that “knowledge-related spillovers from FDI vary considerably across sectors.”5 The same study found that the productivity-enhancing effects of FDI are strongest in the services industries. In Canada, the services sector accounts for over 70 per cent of GDP—with knowledge-intensive services, such as finance and telecommunications, accounting for 18 per cent of total Canadian gross value added. Boosting inward FDI would therefore have a positive impact on Canada’s labour productivity.

      In addition, knowledge-related spillovers from inward FDI depend on the absorptive capacity of host-country firms—that is, the ability of firms to use new technology and processes to improve their productivity.6 The most frequently cited measure of absorptive capacity is one that Canada does notoriously poorly on: research and development activity. R&D activity is positively related to spillover benefits from FDI.7 Canada ranks among the lowest relative to its peers when it comes to business investment in R&D as a share of GDP. Another factor that determines the absorptive capacity of a firm is the quality of its workforce—that is, the technological and management skills of its employees. Absorptive capacity is also better when firms are concentrated geographically.8

      What makes a country an attractive FDI destination?

      Three main factors drive firms to invest in a host country: markets, resources, and efficiency.9

      Canada is not seen as a particularly attractive market for foreign companies to expand their reach. Canada has a small domestic market base, an aging population, and slowing population growth. Setting up shop in Canada should provide access to the large U.S. market, given the Canada–U.S. Free Trade Agreement (FTA) and the North American Free Trade Agreement (NAFTA). But these trade agreements do not seem to have had much of an impact on investor decisions. At over 15 per cent, the U.S. share of world inward FDI stock remains well above that of its peer OECD countries, while Canada’s share continues to fall.

      Canada’s attractiveness is strong on the resources front. Between 2005 and 2009, the mining and oil and gas extraction sector received an average of 32 per cent of FDI inflows into Canada. This allure may fade in the future with investment opportunities growing in more cost-competitive regions such as Latin America.

      What about efficiency? This brings us back to the productivity predicament. Canada needs to attract more FDI as a means of improving labour productivity. Yet Canada’s low labour productivity lessens its attractiveness as an FDI destination. In a 2004 Conference Board survey, executives argued that “a Canadian dollar below $0.70 to $0.75 U.S., combined with lower labour costs can compensate for Canada’s low labour productivity and make the country more attractive for FDI.”10 Now, with the dollar hovering around par, the imperative to improve labour productivity rings loud and clear. Given the cost competitiveness of China, India, and other developing economies in both manufacturing and services, Canada, along with other developed economies, won’t be able to compete when it comes to labour costs.

      What are Canada’s strengths? What should it focus on to attract FDI?

      Canada’s most attractive features as an FDI destination are the skills and the education of its workforce. With high rates of high school and university attainment, high literacy rates, and strong student skills, Canada performs well on the education report card, ranking 2nd overall in this category. But there remain areas for improvement that could boost investment prospects—particularly in relation to R&D and high-technology industries—such as the proportion of PhD graduates, where Canada ranks last among its peers, as well as graduates in engineering and science, an indicator on which Canada gets a “C” grade.

      To boost its FDI attractiveness, Canada should also focus on the state of its infrastructure and the business environment—that is, creating a business environment that is more open to competition and conducive to innovation. Canada has significant barriers to FDI in key industries such as telecom and air transportation.

      Canada also ranks poorly on the OECD’s FDI Restrictiveness Index—a measure of regulatory restrictions on FDI that focuses on “equity restrictions, screening and approval requirements, restrictions on foreign key personnel, and other operational restrictions (such as limits on purchase of land or on repatriation of profits and capital).”11 These types of restrictions to FDI in various sectors of the economy are given scores of between 0 (there are no regulatory impediments to FDI in the sector) and 1 (the regulation fully restricts foreign investment in the sector). The scores for the sectors in each country are averaged to calculate that country’s FDI Restrictiveness Index.

      Among its peers, Canada had the second-highest FDI Restrictiveness Index in 2010 (the higher the index, the higher the restrictiveness to FDI) after Japan.

      For more information on policies to promote inward FDI, see The Conference Board of Canada’s recent publication Best Policy Practices for Promoting Inward and Outward Foreign Direct Investment.

      Footnotes

      1  All inward FDI flows in this discussion have been adjusted using a Hodrick-Prescott filter for cyclical variations. The resulting series are trend shares. Even when not indicated in the text, the figures are referring to trend shares. The Hodrick-Prescott filter is a mathematical tool used in economics to obtain a smoothed non-linear representation of a time series, one that reflects long-term trends rather than short-term fluctuations. Robert Hodrick and Edward Prescott, “Postwar U.S. Business Cycles: An Empirical Investigation,” Journal of Money, Credit, and Banking 29, 1 (February 1997), 1–16.

      2  The data for China includes Hong Kong.

      3  All FDI performance indexes have been adjusted using a Hodrick-Prescott filter for cyclical variations. The resulting series are trend FDI performance indexes. Even when not indicated in the text, the figures are referring to trend indexes. The Hodrick-Prescott filter is a mathematical tool used in economics to obtain a smoothed non-linear representation of a time series, one that reflects long-term trends rather than short-term fluctuations. Robert Hodrick and Edward Prescott, “Postwar U.S. Business Cycles: An Empirical Investigation,” Journal of Money, Credit, and Banking 29, 1 (February 1997), 1–16.

      4  Andrew Sharpe, “The Relationship Between ICT Investment and Productivity in the Canadian Economy: A Review of the Evidence,” CSLS Research Report 2006–05 (Ottawa: Centre for the Study of Living Standards, 2006).

      5  Molly Lesher and Sebastien Miroudot, “FDI Spillovers and Their Interrelationships With Trade,” OECD Trade Policy Working Paper No. 80, October 2008.

      6  Steven Globerman and Victor Zitian Chen, Best Policy Practices for Promoting Inward and Outward Foreign Direct Investment (Ottawa: The Conference Board of Canada, October 2010), 7.

      7  Ibid., 15.

      8  Ibid., 16.

      9  Gilles Rhéaume, Open for Business? Canada’s Foreign Direct Investment Challenge (Ottawa: The Conference Board of Canada, June 2004), 7.

      10  Ibid., 10.

      11  Blanka Kalinova, Angel Palerm, and Stephen Thomsen, “OECD’s FDI Restrictiveness Index: 2010 Update,” OECD Working Papers on International Investment, No. 2010, 3, OECD Investment Division (June 2010), 6.