Features : Latin America on the Path to FDI Recovery

Direct investment in Latin America looks to be growing again after years in decline.

The recipients will be very different this time around.


On the face of it, the state of foreign direct investment (FDI) into Latin America is bleak. FDI flows to the region plummeted last year by 33% to $56.7 billion from $84 billion in 2001, according to data from the United Nations Economic Commission for Latin America and the Caribbean (ECLAC). While flows have been dropping steadily for the past three years, the rate of decline accelerated in 2002 and was proportionately greater than for world markets overall. FDI flows worldwide fell again during the first quarter of 2003, with Latin America leading much of the quarterly decline.

Yet the fact that net FDI inflows to developing countries fell only slightlyto an estimated $23.8 billion during the quarter from $26.6 billion during the same quarter last year, according to data collected by the World Bankcould presage a gradual improvement ahead. The rate of decline has been tempered in part by a surge in FDI flows to China, sharp rises in flows to Russia, steady investment in Mexico and a modest resurgence in M&A; activity in developed countries.

While the volumes may be low, the impact of the investments is still significant. In Mexico, for example, where first-quarter FDI flows were the lowest since the same period in 1998, first-quarter inflows of $2.6 billion were enough to cover the countrys shrinking current account deficit and prompt a reserve accumulation of $4 billion. Mexican authorities are predicting FDI inflows of as much as $13 billion for the full year, a figure that would make it the main destination for FDI flows to the region in 2003.

For countries usually regarded as havens for international investors, however, the advanced stage of privatization in recipient countries, anemic growth among developed economies, ongoing corporate credit retrenchments, and political uncertainty on the domestic front in several markets continue to pose obstacles to full recovery.

Argentina and Brazil are cases in point. FDI inflows to Argentina continued to decline in early 2003, with investors focusing almost exclusively on export-oriented sectors as the country recovers from an economic crisis. Brazil is seeing investor sentiment improve only gradually as the administration of President Luiz Inacio da Silva (Lula) sets its economic plan in motion.

It appears the smaller economies of Central America and the Caribbean are taking an increasingly important share of FDI, prompting an increase in relative terms of FDI dispersal throughout the region. While FDI dropped by 31% in South America last year, the drop for Central America and the Caribbean was a more modest 13%.

Some of the sub-regions markets, including Costa Rica and the Dominican Republic, were particularly appealing. Costa Rica, for example, has become the highest recipient of FDI per capita in Latin America, with FDI flows nearly doubling from $331.4 million in 1995 to $584.8 million in 2002. Figures for the first quarter of this year were encouraging at $125.3 million.

One of the principal features that we like to stress is that there are differences in motivation among investors, says Michael Mortimore, head of the investment and corporate strategy unit at ECLAC headquarters in Chile. Market-seeking investors went predominantly to Mercosur [Southern Cone Common Market] and Chile, but they are not doing so well because markets there are shrinking. Efficiency-seeking investors, on the other hand, have been going to Mexico and the Caribbean, where they are doing better, despite competition from Asia.

According to Mortimore, much of these investments in the sub-region have gone to the apparel sector in markets like El Salvador, Honduras, the Dominican Republic, Guatemala, Costa Rica and, to a lesser extent, Jamaica. The electronics sector has also brought FDI flows especially to Costa Rica and the Dominican Republic. In the latter, local analysts say a 65.5% rise in FDI in 1998-2002 helped ease mounting pressures on a weakening peso by helping to finance the countrys current account deficit.

For Alejandro Izquierdo, a research economist at the Inter-American Development Bank (IADB), part of the relative stability of Central American and Caribbean markets is due to their size, since they are not as heavily exposed to the large portfolio flow changes witnessed by Latin Americas seven largest markets. Emerging markets usually have access to capital markets in sizable amounts, he says, but that is not typically the case in Central America, where most flows come through FDI.

Izquierdo feels that, with economic conditions in Central America and the Caribbean more closely linked to conditions in the United Statestheir main trading partnerthe fact that volatility in US growth has been lower than for other developed markets bodes well for the sub-region. He also points to uncertainty in Latin Americas larger markets as helping their smaller counterparts compete for FDI inflows.

Eduardo Wallentin, senior strategy officer in the Latin America and Caribbean department at the International Finance Corporation (IFC), notes that US-based Intels substantial investments in Costa Rica have also led to a demonstrative effect: Other investors have set up shop in the Central American nation in order to supply Intels manufacturing operations there while others have gone to Costa Rica to grow in Intels shadow.

Wallentin also points to El Salvadorwhere the countrys leaders agreed on a social pact to overcome the effects of political turmoil in the 1980sas another attractive investment site for local and foreign investors alike, given the economic and political stability that has gained the countrys sovereign debt a coveted investment-grade rating.

The prospects for a US free-trade agreement with Central America have improved as the likelihood for implementation of a Free Trade Agreements for the Americas by 2005 wanes, and this has some investors positioning themselves in the region, says Wallentin. The sentiment is that if you go in first, then youll do better, so you have to be a bit of a visionary.

The boom in the development of export processing zones throughout Central America and the Caribbean has been yet another factor supporting FDI flows, as US manufacturers seek to boost efficiency amid the US economic slowdown. Costa Rica and the Dominican Republic have taken the trend a step further by successfully creating clusters of interrelated manufacturing activities, while developing more technology-intensive sectors that attract investors to increasingly sophisticated activities that can be carried out more cost-effectively abroad. While 90% of Costa Rican exports to non-Central American countries involved bananas just two decades ago, its main exports today include microchips and medical devices.


Note: Figures are for net inflows (gross inflows minus capital remittances by the same foreign enterprises). Data for 1990-1994 and 1995-1999 are annual averages. Data for 2002 are estimates. Source: Information Center of the Unit on Investment and Corporate Strategies, ECLAC

More risk-averse investors, however, will likely point to the sub-regions past political turmoil and corruption as drawbacks. Multilateral agencies, including the IADB and the World Bank, have been working closely with Central American and Caribbean governments to streamline state agencies, increase penalties for corruption, monitor intellectual property violations, bring international standards to local accounting practices and improve both corporate and political governance.

According to an IADB report, countries with better political governance are less vulnerable to decreased capital flows prompted by external shocks. But creditor rights are even more important. A one standard deviation increase in political governance reduces the sensitivity of FDI flows to external shocks by more than 20%, notes the report. A one standard deviation increase in creditor rights reduces the sensitivity of FDI to external shocks by approximately 40%.

For Wallentin, the medium-term outlook for FDI flows to Latin America and the Caribbean as a whole is encouraging, since he feels that FDI totals have hit bottom this year and could begin rising by 5% to10% over the next five years. The reversal, he feels, will be aided by a gradual recovery in the global economy that should improve investor sentiment.

Alejandro Izquierdo agrees thatwith large Latin American countries having already made the most of exchange rate adjustments and the changes in fiscal policies required to tackle the sudden stop in capital flows following the Russian crisis of 1998the situation is not dark, and there is indeed scope for recovery.

Santiago Fittipaldi