Geopolitical fragmentation in global and euro area greenfield foreign direct investment

Geopolitical fragmentation in global and euro area greenfield foreign direct investment

Prepared by Lukas Boeckelmann, Lorenz Emter, Isabella Moder, Giacomo Pongetti and Tajda Spital

This box reviews recent developments in global and euro area greenfield foreign direct investment (FDI) and analyses the role of geopolitics in shaping these. As firms and policymakers increasingly look at ways to reduce the vulnerability of their supply chains, understanding recent dynamics in greenfield investment is important as these may foreshadow a reconfiguration of global trade networks, the fragmentation of which could be particularly detrimental for the euro area.^[1] Greenfield FDI flows refer to foreign investments made by companies to build new or extend existing production capacity. In the last decade, annual FDI outflows and inflows amounted to 1.4% and 0.6% respectively of euro area GDP and 1.0% and 1.2% respectively of global GDP excluding the euro area. The euro area is the largest source of outward greenfield FDI, accounting for 19% of global outflows in the last two years, followed by the United States, which accounted for 15%. This box uses information on announced greenfield FDI projects from a dataset provided by fDi Markets.^[2]

Ex ante, the effect of geopolitical fragmentation on the direction of FDI flows is ambiguous. On the one hand, firms and policymakers might look to friend-shore and/or near-shore production to make supply chains less vulnerable to geopolitical tensions or to safeguard their assets from potential future violations of property rights. On the other hand, firms might increase their investments in geopolitically distant countries, i.e. countries which take an observably different stance on foreign policy issues, if they think that future trade tensions might impede their access to local markets.

Aggregate greenfield FDI flows are already showing increasing signs of fragmentation along geopolitical fault lines. Western companies have been ramping up investment in friendly (western) countries, while lowering investment in geopolitically distant (eastern) countries.^[3] Greenfield FDI flows within the western bloc have been on the rise since 2016, while flows between the eastern and western blocs have declined, suggesting that western companies are increasingly friend-shoring or near-shoring their production capabilities (Chart A). The increase in greenfield investment within blocs is in line with evidence collected from earnings calls, which have seen a noticeable uptick in references to “friend-shoring”.

Chart A

Global greenfield FDI flows

(four-quarter moving averages, USD billions)

Euro area outward flows have followed the same trend, with greenfield investments increasingly tilted towards geopolitically friendly countries, such as the United States. Euro area FDI outflows seem to be increasingly pulled towards western bloc countries, in particular the United States. One driver may be that euro area firms are trying to increase their local production content for the US market in response to incentives created by the US Inflation Reduction Act (IRA).^[4] Flows of greenfield FDI into the euro area are, in turn, dominated by US investments, which accounted for more than 30% of overall inflows in 2023. The recent pick-up in investment in the euro area appears to be part of a broader trend of rerouting US investments away from China to the benefit of more friendly and neutral countries.

While flows between opposing blocs have been relatively contained, there is also evidence that firms have stepped up investment between geopolitical blocs in anticipation of protectionist measures and retaliatory tariffs. Available data suggest that the flow of Chinese FDI to the neutral and western blocs increased steeply around the time the IRA was passed into law. This suggests that, in response to the heightened domestic content requirements introduced by the IRA, Chinese firms shifted their production in order to bypass the trade restrictions imposed on their goods (Chart B, panel a). This mirrors similar developments after 2016 when the threat of higher US tariffs on Chinese goods coincided with an increase in Chinese FDI flows to the western and neutral blocs. Moreover, while overall greenfield FDI flows from the euro area to China are on a declining trend, German firms, mainly driven by the automotive sector, have increased their investment in China in recent years. At the same time, we see evidence of Chinese companies increasing domestic production content in the EU, mostly in non-euro area countries, particularly Hungary (Chart B, panel b). This might also be due to firms pre-emptively relocating their production in anticipation of rising trade tensions.

Chart B

Greenfield FDI from China

a) Chinese outbound FDI to geopolitical blocs	b) Chinese outbound FDI to the EU and the euro area

A more formal econometric analysis suggests that fragmentation along geopolitical fault lines has increased over time. We employ a gravity model for FDI flows that distinguishes between flows within the western and eastern blocs and flows between the blocs.^[5] The results suggest that trends in global FDI flows along geopolitical fault lines, as shown in Chart A, were not driven by country-specific characteristics (such as economic growth) and instead reflect increasing geopolitical fragmentation. Independent of geographic distance, it is estimated that FDI flows within geopolitical blocs were almost three times higher than FDI flows between geopolitical blocs in the three years up to the first quarter of 2024 (Chart C).

Chart C

Ratio of FDI flows within blocs to FDI flows between blocs

(ratio)

Econometric evidence shows that the overall effect of geopolitical divides on FDI is negative. We find that the effect of geopolitical distance on global and euro area greenfield FDI flows has increased since Russia’s invasion of Ukraine (Chart D).^[6] Our estimates suggest that the widening geopolitical divide has dampened global FDI flows by around 3% (or €30 billion).^[7] For the euro area, the value of announced greenfield FDI projects is also significantly smaller in destination countries that are geopolitically more distant, and this negative relationship has become much more pronounced since the Russian invasion of Ukraine, with annual flows falling by €14 billion. Moreover, we find that the increase in geopolitical distance between the euro area and China over the same period is associated with a decrease of around 20% in the value of flows between the two areas.^[8]

Chart D

Effect of geopolitical distance on value of bilateral greenfield FDI flows over time

(elasticities, percentages)

The impact of the shifts in FDI on trade and euro area output remains uncertain. On the one hand, a shift by euro area firms to increase production in the United States or other countries – for example, in response to domestic content requirements – may dampen production at home. On the other hand, higher FDI outflows may safeguard the overall competitiveness of European exporters and may, for example by increasing FDI income streams, preserve some domestic jobs, particularly in high-skilled corporate services. Moreover, euro area and other EU countries also appear to have benefited from inward FDI, which has averaged 0.7% of GDP since 2022, exceeding pre-pandemic levels.^[9] More broadly, to the extent that a change in global greenfield FDI patterns along geopolitical lines foreshadows an accelerating fragmentation of global trade networks, the trends detected may prove detrimental to global and euro area output. Given its greater openness to trade and stronger integration into global value chains, such fragmentation would be more detrimental for the euro area than for other large economies.^[10]

1. Geoeconomic fragmentation of trade would be detrimental to the euro area, lowering GDP by more than 2% and raising consumer prices by almost 4%. See also the box entitled “Friend-shoring global value chains: a model-based assessment”, Economic Bulletin, Issue 2, ECB, 2023.

2. The data are collected primarily from publicly available sources (e.g. media outlets, industry organisations and investment-promoting agency newswires) and report investment-level information for over 300,000 greenfield FDI announcements between 186 countries starting in January 2003.

3. To analyse FDI fragmentation, the world economy is assumed to fragment into three distinct blocs: a “western” (United States-centric) bloc, an “eastern” (China-centric) bloc and a “neutral” bloc comprising non-aligned countries. This classification is based on the geopolitical index outlined in the special feature entitled “Geopolitical fragmentation risks and international currencies”, The international role of the euro, ECB, June 2023.

4. The IRA significantly steps up US efforts in the fight against climate change and aims to increase the ability of the United States to attract key green technologies. It provides for significant financial incentives (such as tax credits for the purchase of electric vehicles and investment in renewable energy equipment) that are conditional on specific domestic content requirements.

5. We estimate a gravity model for quarterly greenfield FDI flows between nearly 200 source and destination countries for the period from the first quarter of 2003 to the first quarter of 2024, using dummy variables for FDI flows within and between the geopolitical blocs. The gravity model assesses the flows within and between the western and eastern blocs against a third category, “other”, encompassing flows between these two blocs and neutral (non-aligned) countries and flows between neutral countries.

6. Instead of including dummy variables for geopolitical alignment as above, we use geopolitical distance as measured by an index proposed in Bailey, M.A., Strezhnev, A. and Voeten, E., “Estimating Dynamic State Preferences from United Nations Voting Data”, The Journal of Conflict Resolution, Vol. 61, No 2, February 2017, pp. 430-456, which is based on voting patterns in the United Nations General Assembly in order to proxy geopolitical distance, following Aiyar, S., Malacrino, D. and Presbitero, A.F., “Investing in friends: The role of geopolitical alignment in FDI flows”, European Journal of Political Economy, Vol. 83, June 2024.

7. These effects are relative to a counterfactual of no geopolitical tensions – but not necessarily relative to a counterfactual in which firms do not respond optimally to the associated risks by diversifying supplies and production and by buying insurance against future shocks.

8. These results are robust to excluding Russia from the sample, so we can exclude the possibility that a general decoupling between the West, in particular the euro area, and Russia is driving the larger coefficient estimates in the most recent period. Moreover, the extent to which the euro area may have become generally less attractive as an investment location, owing to its proximity to the conflict and, for example, the energy price shock it triggered, would be controlled for by the time-varying destination country fixed effects.

9. These developments are comparable to the United States, where FDI inflows have averaged 0.6% of GDP since 2022, also exceeding pre-pandemic levels.

10. See the box entitled “Friend-shoring global value chains: a model-based assessment”, op. cit.