Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : Three Common Misperceptions About Foreign Direct Investment, July 15, 1988

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u.s. current-account

deficits, and
there is apparently no simple relationship between the current-account
balance and the volume of IDI.
Instead; the dollar's foreign exchange
rate, the stage of the business cycle,
expectations of protectionist actions,
direct investment opportunities
abroad, income opportunities from
portfolio investment, and a host of
other considerations moderate the
fact that, other things equal, an
increase in the current-account deficit
should be accompanied by an
increase in IDI.
Also contrary to popular perception is
the fact that Japan is not the largest
source of IDI, even though it has the
largest current-account surplus. The
Japanese direct investment position
in the United States is far exceeded
by those of some other nations, and
even in recent years, the inflows from
Japan have been exceeded by those
from the United Kingdom, a nation
that does not have a large currentaccount surplus.
In addition, although many observers
view the direct investment inflow
with alarm, their concern may be
unwarranted. First, IDI and the resulting foreign investment position in
America are not larger than the U.S.
direct investment outflow and position abroad. Second, the inflow can
provide an infusion of new management, new technology, and new
employment. Finally, it seems

July 15, 1988
unlikely that foreign owners of assets
in the United States are likely to want
to, or be able to, use those assets in
detrimental ways.
•

Footnotes

1. Although there is some debate among
economists about the direction of causality, the assumption here is that a currentaccount deficit causes a net capital inflow.
2. Foreign, or inward, direct investment
(JDJ) in America is the flow of foreign
lending to, or equity investment in, a U.S.
firm or property that the foreign investor
controls. Foreign portfolio investment in
the United States is foreign purchase of
U.S. securities that does not result in control of a U.S. firm. The cumulative total of
all past IDI is the foreign direct investment
position in the United States.
U.S. investors can make direct investments
abroad, or outward direct investment. The
cumulative total of these investments is
the U.S. direct investment position abroad.
3. Different sets of incentives guide IDI
and inward private portfolio investment.
Direct investors are often foreign manufacturers or retailers acquiring manufacturing
or distribution facilities in the United
States. Portfolio investors are often banks,
insurance companies, and portfolio managers acquiring stocks and bonds or lending in America. Because the direct investor
acquires assets that are much less liquid
than those acquired by a portfolio investor, he typically would take a longer-run
view of the prospects for his investment.
Moreover, a direct investor would be
interested in the outlook for a particular
industry, while a portfolio investor purchasing bonds would be interested in the
outlook for interest rates. Thus, there need
not be any similarity between trends in
101 and inward private portfolio
investment.

4. Similarly, a current-account surplus
should be accompanied by a net capital
outjlow of equal size.

Box

Federal Reserve Bank of Cleveland

6. On the other hand, dollar depreciation
also discourages inward direct investment
because it causes a foreign investor's U.S.
dollar profits to translate into fewer units
of the investor's home currency.

____

7. Both positions may be understated
because they are measured on a historical
cost basis.

Gerald H. Anderson

n the last few years, Ohioans have
seen foreign investors acquire or
increase their equity interest in such
well-known Ohio firms as Sohio,
Libby-Owens-Ford, Hanna Mining
Company, White Consolidated Industries, General Motors' Terex
Division, and many others. At the
same time, foreign firms have established entirely new subsidiaries in
Ohio, the best known of which is
Honda of America Manufacturing,
which produces both motorcycles
and automobiles.

9. Ibid.

Gerald H Anderson is an economic advisor at the Federal Reserve Bank oj Cleveland The author appreciates the able
research assistance protnded by Christine
Dingledine.
The views stated herein are those oj the
author and not necessarily those oj the
Federal Resene Bank oj Cleueland or oj
the Board oj Governors oj the Federal
Reserve System.

This increasing foreign presence in
Ohio is part of a national trend of
accelerating foreign investment in
America. While many Americans have
welcomed the infusion of foreign
capital and entrepreneurship,
some
have worried about its implications
for U.S. economic independence.
Others have argued that, whether we
like it or not, the increased foreign
presence is an inevitable result of
large U.S. current-account deficits.

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Permit No. 385

6387

Three Common Misperceptions
About Foreign Direct Investment
by

8. Ned G. Howenstine, "U.S. Affiliates of
Foreign Companies: Operations in 1986,"
Survey oj Current Business, U.S. Department of Commerce, Bureau of Economic
Analysis, vol. 68, no. 5 (May 1988), pp.
59-75.

Federal Reserve Bank of Cleveland
Research Department

P.o.

eCONOMIC
COMMeNTORY

5. Some other countries also have some
of these attributes. In addition, some have
low-cost labor or raw materials or tropical
growing conditions that are not as readily
available in America. Consequently, U.S.
investors make direct investments in other
countries. Geographic diversification is
also a reason for outward direct investment. Until 1980, U.S. outward direct
investment in a year usually exceeded
inward direct investment.

Cleveland, OH 44101

And some have assumed that because
Japan is the nation with the largest
current-account surplus, it must also
be the source of most of the investment inflow into the United States.
Popular beliefs about the threat to U.S.
economic independence,
the association between foreign direct investment and the current-account deficit,
and the importance of Japanese direct

Material may be reprinted provided that
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P.O. Box 6387, Cleveland, OH 44101
ISSN 0428-1276

investment are all based on rnisperceptions. By discussing the implications, causes, and sources of foreign
direct investment in America, this

Economic Commentary attempts to
dispel these three misperceptions.
• Reasons for Foreign Direct
Investment in the United States
Since 1982, the United States has
incurred large annual deficits in its
current-account balance, the inevitable counterpart of which has been
large net capital inflows.' Although
observers often suggest that the large
current-account deficits make large
flows of foreign, or inward, direct
investment (IDI) inevitable, the
annual volumes of IDI in these years
have been only loosely related to the
current-account balance.'
The net capital inflow into the United
States is the sum of several inflows
and outflows. It equals IDI, plus
inward private portfolio investment,
less outward direct investment, less
outward private portfolio investment,
plus or minus the inflow or outflow
of government capital.'
In theory, the sum of these flows (the
net capital inflow) should be exactly
equal to the size of the currentaccount deficit.' In practice, however,
the measurement errors have been
quite large, and the statistical discrepancy between the two annual sums
frequently has exceeded $20 billion.

The increasing purchase of U.S.
assets by foreigners in recent years
has been blamed on the currentaccount deficit, has been attributed
to the Japanese, and has caused
alarm about loss of U.S. economic
independence.
These three common
views are based on misperceptions
about the causes, sources, and implications of foreign direct investment.

Because of the measurement errors
and because of the number of other
capital flows in the equation, any
amount of IDI can be compatible
with any current-account balance.
In the last quarter century, there has
been a positive amount of IDI in
every year, even though the current
account has been in deficit in only 10
of those years (see chart 1). Chart 1
does not suggest any obvious relationship between the size of the currentaccount balance and IDI. In fact, careful examination of the chart reveals
that the changes in the two series have
the same sign almost as often as the
changes have opposite signs, thus failing to support the idea that changes
in the size of the current-account balance cause changes in the size of IDI.

CHART 1 DIRECT INVESTMENT VS. CURRENT-ACCOUNT BAIANCE
Billions of dollars

Investment in the United States also
offers a foreign investor the advantage
of geographic diversification."
The tendency for the annual, currentdollar volumes of IDI to grow
through time may result from the
world economy's real growth, which
fosters growth of the vol ume of
annual saving available for investment, and from the decline in the
purchasing power of the dollar.

-]-10
-160~-"""'--L--~--~--'----L-----&'_---I~

1964 ]967 1970 1973 1976 1979 1982 1985 1988
SOURCE: L'.S. Department of Commerce. Bureau of Economic Analysis.

CHART 2 DIRECT INVESTMENT POSITIONS
Billions of dollars

350[
300
250

Recently, some additional developments have encouraged IDI, probably
contributing to its upswing in the last
four years. Perhaps most important is
that the dollar has depreciated greatly
against other major currencies since
early 1985, making it more difficult
for goods produced abroad to be competitive in the U.S. market. For example, the depreciation has caused the
dollar value of wage rates in some
other major countries to rise relative
to U.S. wage rates. Consequently, foreign firms who want to sell in the U.S.
market have increased incentive to produce their goods here. Moreover, dollar depreciation has lessened the cost
of purchasing U.S. production facilities when measured in the currency
of the potential foreign Investor." The
U.S. stock-market crash of October
1987 also has reduced the cost of
purchasing existing U.S. firms, which
probably will encourage lDI in 1988.

Another likely cause of the recent
O~--~--~----~--~--~----~--~--~~
acceleration of lDI is that the persist-

]97] 1973 1975 1977 1979 1981 1983 1985 1987
SOURCE: l '.S. Department of Commerce, Bureau of Economic Analysis.

This cursory analysis suggests that the
current-account balance does not
provide a simple and complete
explanation of lDI, and shows that
lDI is not an inevitable result of the
large U.S. current-account deficits.
While the current-account balance
provides no simple explanation for
the level or the changes in the
volume of IDI, several other factors
help to explain the rather continuous
inflow of direct investment, the tendency for lDI to grow through the

years, and the swings in its volume in
the last 10 years.
Several relatively permanent attributes
continuously provide strong incentives for ID!. For example, the United
States has a very large and growing
market, a stable economy, a strong
commitment to free enterprise and private property rights, military security,
excellent capital markets, freedom for
foreign owners to repatriate their capital and earnings, and ample supplies
of skilled labor and raw materials.

ent large U.s. trade deficits of recent
years have strengthened protectionist
sentiment. Some foreign firms, especially Japanese vehicle manufacturers,
could have decided to produce their
products in the United States to
soften protectionist sentiment and to
hedge against the possible loss of
market share if protectionist legislation were to be enacted. The persistence of the current U.S. economic
expansion probably added to the
attractiveness of ID!.
The rise in lDI in the late 1970s was
probably encouraged by the depreciation of the dollar and by the U.S. economic expansion in that period.
Then, dollar appreciation in the first
half of the 1980s, together with the
recessions in the 1980-1982 period,

probably contributed to the fall-off in
IDI volume in 1981, 1982, and 1983.
• Direct Investment Positions
At the end of 1987, foreign investors
had accumulated a direct investment
position in the United States totaling
$262 billion. Similarly, U.S. investors
hadaccumulated
a direct investment
position abroad valued at $309 billion.? The difference between those
two positions. $47 billion, is the net
direct investment position of the
United States.
The net position declined from $132
billion in 1980 to $47 billion in 1984
and then leveled off, with no net
change in the last three years (see
chart 2). The sharp decline in the 19801984 period resulted as the U.S. position abroad stagnated, declining by
$4 billion, while the foreign position
in the U.S. doubled, rising by $82 billion. Important contributors to the
stagnation of the u.s. position abroad
in 1980-1984 were the appreciation of
the dollar, which caused foreigncurrency-denominated
U.S. assets
abroad to translate into fewer U.S.
dollars, and borrowing by u.s. parent
companies from their foreign
affiliates.
European investors held two-thirds of
the $262 billion foreign direct investment position in the United States at
the end of last year. British investors
held the largest share, 29 percent,
while Dutch investors held 18 percent. Despite all of the publ icity that
Japanese investment in the United
States has received, the Japanese
share of the total was only 13 percent.
Other measures also fail to support
the popular perception that Japan,
with its massive surplus in trade with
the United States, is the largest foreign direct investor here. For example, Japanese spending to acquire or
establish U.S. enterprises was jess
than that of the United Kingdom and
Canada in 1986, and less than that of
the United Kingdom in 1987. Moreover.japan ranks behind the United
Kingdom, Canada, West Germany, and
the Netherlands in the number of its
U.S. employees. At the end of 1986,
Japan ranked far behind Canada, the
United Kingdom, and the Netherlands
in the gross book value of property,

plant, and equipment in America
owned by firms whose ultimate
owners resided in those countries.
• Foreign-Owned
the U.S. Economy

Firms' Shares of

Recent increases in foreign direct
investment in the United States have
raised concerns about the degree of
foreign influence in our economy. The
foreign direct investment position
here at the end of 1987 was 91 percent larger than just four years earlier.
Foreign-owned firms' shares of U.S.
employment, assets, and sales show
that foreign involvement in the U.S.
economy is substantial and growing.
Employment by foreign-owned nonbank firms in 1986 (latest data available) accounted for 3.5 percent of
employment of all nonbank firms in
the United States, up from 3.2 percent
in 1981. In manufacturing, employment by foreign affiliates accounted
for 7.8 percent of total u.s. manufacturing employment,
cent in 198J.8

up from 6.9 per-

Foreign involvement in U.S. manufacturing is even larger when judged by
shares of sales and assets. Foreign
affiliates held a 9.9 percent share of
the sales of all U.S. businesses in
manufacturing in 1986, including
shares of 30 percent in chemicals and
allied products, 20 percent in stone,
clay, and glass products, and 19 percent in primary metal industries. The
foreign share of manufacturing assets
was 12.1 percent, including shares of
33 percent in chemicals and allied
products, 23 percent in stone, clay,
and glass products, and 21 percent in
primary metal industries."
Foreign investors are much more
likely to acquire an existing enterprise than to start a new one. In 1987,
for example, foreign investors used
$25.6 billion to acquire existing
enterprises and only $4.9 billion to
establish new enterprises. In the
same year, newly acquired enterprises
had 331,000 employees, while newly
established enterprises had only
15,000 employees.
• Implications of Foreign
Direct Investment
Cries of alarm have accompanied the
increases in the volume of u.s. physi-

cal assets owned by foreigners. Usually, the alleged dangers are not
stated very specifically, but they seem
to center on the idea that the United
States somehow could lose control of
important industries and thereby lose
control of its economic destiny. The
concern about IDI has led to proposals for legislation that would require
closer monitoring, or even restriction,
of investment.
Despite the alarm being expressed in
some quarters, there are several defenses for and benefits of ID!. First,
the U.S. direct investment position
abroad is larger than the foreign position in the United States (see chart 2).
Moreover, even though the gap between the two positions narrowed
substantially in the early 1980s, it has
not narrowed since 1984, because the
flow of outward direct investment has
roughly matched the enlarged inward
investment flow.
Second, foreign
U.S. enterprises
infusion of new
technology, and

acquisition of existing
sometimes brings an
capital, improved
better management.

When IDI creates a new enterprise,
the new facility provides new jobs,
increasing total employment or at
least displacing a less-efficient
competitor.
Third, foreign owners are subject to
the same laws protecting labor, investors, the environment, and so forth as
are domestic owners. They also have
the same economic incentive to use
their U.S. holdings efficiently and
profitably, that is, in ways that are
beneficial to the United States.
Moreover, because most foreign
ownership of U.S. assets is lodged in
major industrialized democracies that
are friendly to America, the possibility
is very remote that foreign governments would prevail upon foreign
owners to use their U.S. holdings in a
way that is detrimental to us. The
possibility is even more remote that
U.S. legislation could not successfully
counteract any such hostile efforts.
•

Conclusions

Contrary to popular belief, foreign, or
inward, direct investment is not an
inevitable result of the recent large