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Merger mania goes global

Prof. William Milburg*

New York, 30 Oct 2000 — In the wake of the financial crises that struck Mexico, Thailand, South Korea, Russia and Brazil in the 1990s, capital-starved developing countries are increasingly seeking to meet their needs by attracting foreign direct investment (FDI) instead of portfolio capital inflows. Along with a broad-based recognition of the potentially destabilizing effects of volatile international financial markets, has come an increasing hope that FDI can provide a stabilizing source of capital required for industrialization and development.

In this context, the annual World Investment Report (WIR2000) has taken on increasing importance as a source of information on trends in FDI.  This year’s report is the tenth.  In its early years the report came out of the UN Center on Transnational Corporations.  The center has been folded into UNCTAD and so the reports have become increasingly concerned with the effects of TNC behaviour on developing countries.

The arguments favouring inward FDI, and one which is appealing to developing countries is that, unlike bank loans or other forms of debt, it requires neither a fixed interest payment nor a repayment of principal at a specified date.  Moreover, FDI shouldn’t be as volatile as portfolio flows since, as fixed investment in plant and equipment, FDI isn’t especially liquid and constitutes a long-term commitment by foreign owners to the economy of the host country.  Specifically, inward FDI is said to bring gains in employment, technological spillovers, and export market access, and even to encourage domestically-owned firms to become more competitive. According to a recent OECD study,  “Like trade, foreign direct investment acts as a powerful spur to competition and innovation, encouraging domestic firms to reduce costs and enhance their competitiveness.”

There is good reason for countries to look to FDI as a substitute for portfolio capital to meet their investment needs.  According to WIR2000, FDI increased globally at a stunning rate of 31.9% per year between 1996 and 1999, reaching a value of over US$800 billion in 1999, compared to only US$58 billion in 1982.

But amidst the blizzard of upward-sloping lines in the WIR2000 representing these FDI trends, we find that a qualitative shift in FDI has also occurred, and one which challenges the popular image of FDI as “bricks and mortar”.  Early on in this 337-page report we learn that almost all of the world’s FDI is now done in the form of cross-border Mergers and Acquisitions (M&A).  This phenomenon is the focus of this year’s WIR2000. For developed countries, 100% of inward FDI was inward M&A in 1999, up from 80% in the mid-1990s.  In developing countries the figure was closer to 40%, with considerable variation across regions - from 20% in developing Asia to 60% in Latin America and the Caribbean (pp. 117). Given these figures, it might be advisable to drop the term FDI entirely for the more precise term, “cross-border M&As”.   Even this would be a misnomer for most developing countries, since most activity of this sort falls into the “Acquisitions” category.  At a minimum, as FDI grows and cross-border M&A activity grows even more rapidly, it is important that we confront the popular image of FDI - as development/employment/output/ human-capital friendly bricks and mortar - with the reality.

Despite its new M&A face, FDI continues to be a phenomenon largely among developed countries. In fact, the developing-country share of world FDI has actually fallen since 1994 (p. 20).  And of the FDI flows to developing countries, there is a highly skewed distribution.  Over the period 1993-1998, China received over 25% of all FDI to developing countries, with Brazil, Mexico, Argentina and Malaysia accounting for another 22% (p. 23).

Despite the emphasis on the ‘brick and mortar’ approach to FDI found in the WIR (and among many policy-makers in both developed and developing countries), the M&A boom makes it increasingly difficult to distinguish FDI from portfolio investment.  This is not altogether a new concern, as the definition of FDI as investment bringing a 10% or greater share ownership is based as much on convention as economic significance.  The distinction was blurred further in the past decade: With the expansion of financial markets, both geographically and in terms of the variety of financial instruments available, FDI could now be hedged by parent TNCs expanding their financial liabilities in host countries.  According to UNCTAD economist Jan Kregel, this covering of risk, “will produce cross-border flows that put pressure on the foreign exchange market or the domestic money market, which may reinforce other destabilizing elements.”  This link had already raised a question about whether FDI is inherently more stable than other forms of capital flows.

Now the wave of international M&A activity makes the distinction even less clear.  Unfortunately, this point is not adequately dealt with in this year’s WIR. International acquisitions are financial transactions, and their explosion in the past three years must be seen as a function of the increasing strategic necessity of firms to compete internationally.  The strategy is driven both by oligopolistic tendencies of consolidation comparable to those observed in the late 19th century in the U.S. for example, and of the need for portfolio diversification.  Expanding the firm’s assets internationally facilitates the diversification of both costs and revenues, so important for smoothing profitability when currency values are so volatile.  Privatization has been an important aspect of M&A activity, with telecommunications and electrical services being the source of most cross-border M&A transactions in the last few years.  Most acquisitions are not cash transactions but stock transfers and made possible by the historic shift to equity financing even in emerging markets and in an apparent secular shift upward in price-to-earnings ratios in existing and emerging stock markets.  In this context, currency crises create great opportunities for TNC buy-outs.

The WIR2000 reduces the distinction between traditional FDI (“greenfield”) and M&A FDI (“brownfield”) as simply a difference in the “mode of entry” of foreign capital.  The question of the effects of M&A then is reduced to that of whether or not the “mode of entry” matters for host developing countries.  The conclusion of WIR2000 is that although in the short run the M&A will generate less new employment and may increase concentration, over the long-run there is no difference to the host developing country between different modes of entry in terms of employment generation (p. 183), crowding out domestic investment (p.  171), and technology spillovers.  There is certainly an ample listing of the potential pitfalls of M&A activity for the host country, but in the final analysis, “host-country impacts of FDI are difficult to distinguish by mode of entry once the initial period has passed - with the possible exception of market structure and competition.” (p. XXV); unfortunately, the implications of this important qualification for developing countries are not analysed in the report.

The WIR2000 does an excellent job of describing the rise of international M&A activity.

But there are at least three problems with the analysis.  The first is the one discussed above—that M&A activity is now too far removed from the “bricks and mortar” concept of FDI to be usefully analyzed with the same lens. The M&A explosion may be much closer to a financial bubble than it is to a developmentalist phenomenon.  The explosion thus should be assessed in the context of a theory of international finance, financial regulation and macroeconomics. In the U.S. context, for example, there is scant evidence of the positive employment and wage effects of the domestic boom in merger activity - except of course in the financial services industry that brokers the transactions.  Second, the report fails to connect the crowding out effects of FDI to the M&A.  Manuel Agosin’s UNCTAD Discussion paper (cited in the WIR2000, but not fully presented) shows that FDI tends to crowd out domestic investment in Latin America and “crowd in” investment in East Asia.  According to the WIR2000 (p. 117), the share of M&A in FDI in Latin America was 60% while it was close to 20% in Asia, indicating at least a prima facie case that M&A based FDI is more likely to be associated with crowding out than crowding in.

Finally, the Report admits that “the analysis is often conceptual, but draws on empirical evidence and experience whenever possible”.  Unfortunately, this evidence is largely specific cases that are described in boxes offset from the main text.  As such they beg the question of their general relevance.  More problematic is that although the analysis is “conceptual”, it contains no clear cut theory of the TNC, especially in this era where financial market considerations loom so large in strategic decision-making.  TNCs are viewed as a set of assets (skills, technology, capital, export market access) that “rub off” on the host country market to a greater or lesser extent.  Since some is less than none at all, then the conclusion of the net benefit of TNC activity is positive, regardless of mode of entry.  Since FDI, especially in the manufacturing sector, is often motivated by firms’ desire to have an internationally integrated and flexible production process, it is believed that developing countries that fail to attract foreign firms risk being shut out of these growing firm-level, internationally integrated, flexible production “networks”, that is, to be left out of the entire process of the globalization of production, including international trade. Recent work also published by UNCTAD for the Group of 24 (including a paper by this author) casts serious doubts about this kind of analysis.

This conceptual framework reminded this reviewer of the comment by Cambridge economist Joan Robinson,  who wrote in her treatise critical of Marxian economics that “the only thing worse than being exploited is not being exploited at all.”   This would seem to be the motto of the World Investment Report.  But as world investment decisions become increasingly driven by financial market considerations and stock market developments, the warning of another Cambridge economist - John Maynard Keynes - would seem more appropriate for developing countries: “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”- SUNS4772

(* Professor William Milburg is Associate Professor of Economics at New School University, New York, and wrote this review of  ‘World Investment Report, 2000: Cross Border Mergers and Acquisitions and Development’, UNCTAD for the SUNS.)

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