Foreign direct investment in deflationary regimes: Evaluating recent European Union experience

In the aftermath of the recent financial crisis, changes in the levels and patterns of investment had a devastating effect on overall economic activity. Foreign Direct Investment (FDI) could not have failed to remain unaffected. Nevertheless, besides the severe recession that hit most European Union (EU) countries, as well as the resulting downward trend in EU inflation especially since the beginning of year 2012 and the near-zero and negative levels it reached since the last quarter of year 2014, FDI levels in certain EU countries have bounced back during post-crisis years. In the current research we evaluate the effect of deflation on intra-EU FDI. Deflation is associated with a lower level of demand in the economy and may stem from a reduction in the supply of money or credit or a fall in private, investment or government spending. If deflation persists or if, even while short-lived, it manages from its outset to alter expectations formation towards a bleak economic outlook, it is bound to cause a negative effect on investment. However, low production cost opportunities may arise, and low collateral values and falling interest-rate levels (which tend to be associated with deflation in the FDI inward countries) may give rise to beneficial credit opportunities for outward FDI companies. Additionally, in deflationary regimes, high prospects of institutional change and privatization of state-owned enterprises, which tend to exploit large economies of scale (stemming from infrastructure or ownership benefits over monopolies), may constitute major advantages for inward FDI. Therefore, while deflation has an uncontested, yet dubious effect on FDI, the latter is also bound to affect economic performance positively; thus giving a push to aggregate demand, which may contribute to a halt in or even elimination of deflation. We evaluate the effect of recent EU deflation on intra-EU FDI by estimating causal effects between FDI from ‘core’ to ‘periphery’ EU countries and the variability in the general price level (different indexes and EU country groups modeled at par). We estimate a two-equation model that treats both variables as endogenous and use panel data that span from 1970-2015, in order to include two major incidents of deflation in countries that at present are EU members. We expect to get statistically significant support that deflation has accounted for the aforementioned increase in FDI levels in certain EU countries.