Key highlights

Over the past two years, the future of foreign direct investment (FDI) has been assessed largely through the prism of the pandemic and its impact on the global trade landscape. However, it is becoming increasingly clear that the rise of protectionist policies and national security tensions, which have become heightened by the war in Ukraine, remains a central concern.

To better understand how the SDGs and ESG-related considerations are driving decisions around FDI and supply chain relocation, Economist Impact conducted a global survey of 376 C-suite executives from multinationals in the energy, finance, healthcare, IT and manufacturing sectors. In this article we assess how geopolitical factors could shape FDI choices and their implications for sustainability considerations.

An unsettled backdrop

According to our survey, political stability is among the three factors considered most important by organisations when making FDI location decisions. It is likely that policy uncertainty, especially related to trade and FDI regulations, lies at the heart of this focus on political stability. Our study also finds that while covid-19 has caused the most disruption to their FDI decisions over the past five years, the US-China trade dispute and Brexit ranked second and third respectively—the three factors being linked by the supply-chain fragilities exposed and exacerbated by the pandemic.

Yet Donald Trump’s departure from the White House failed to bring an end to US-China trade tensions. While the administration of Joe Biden has brought a more diplomatic approach to proceedings, there remain significant points of contention between the two countries. The Biden administration, which will continue to periodically review supply chains in areas considered important for national security, has also signed legislation banning certain Chinese tech companies, such as Huawei, from operating in the US.

More than six in ten energy and natural resources organisations that responded to our survey said that US-China frictions have had a disruptive or significantly disruptive impact on them, as did more than half of those in the finance and healthcare sectors. Almost 60% of US organisations across all sectors also reported that the trade dispute has been disruptive or significantly disruptive to their FDI decisions over the past five years, rising to nearly two-thirds among those in the Asia-Pacific region. Only 7% of respondents in the latter group said that they had not suffered any such disruption.

Figure 1. On a scale of 1 (no impact) to 5 (very significant impact), to what an extent has the US-China trade war had a disruptive impact on your organisation’s FDI decisions over the past five years?

In other words, even as the covid-19 pandemic unfolded and organisations faced a raft of other difficulties, geopolitical forces remained hugely influential on their decision making. The challenge for multinationals is that even with operations spanning the globe, their country of origin has significance from a national security perspective.

Given the crucial intersection between security concerns, foreign investment and SDG fulfilment, it seems likely that greater protectionism adds to the headwinds facing efforts to meet the SDG. For instance, the United Nations Conference on Trade and Development (UNCTAD) says that the non-tariff measures (NTMs) that have risen in prominence in recent years have a direct impact on ten out of the 17 SDGs. Investment regulations, especially inward FDI screening policies, could also have a negative impact on SDGs if they either deter FDI directly or indirectly due to increased uncertainty.

Post-pandemic nervousness

Since 2018, more than half of the 37 OECD countries have had investment screening mechanisms in place, compared with a third a decade earlier. The OECD has also reported an increase in the number of governments that have given themselves power to take action against both proposed FDI deals and those already completed.

This has accelerated since the onset of the pandemic. According to UNCTAD’s 2021 World Investment Report, the number of investment policy measures of a regulatory or restrictive nature more than doubled in 2020. It noted increased use of screening mechanisms driven by national security concerns over FDI in sensitive industries.

Screening is especially advanced across developed nations with infrastructure or assets that they want to protect. For instance, a UK government Act that took effect at the start of 2022 introduced a new national security vetting regime that is expected to have a particular impact on investments in sensitive sectors and technologies. The new regime applies to investments and acquisitions by investors from any country and gives the UK government the right to "call in" acquisitions that potentially give rise to national security risks. Similarly, 18 of the 27 EU member states had some form of screening mechanism in place as at September 2021, with several others planning to introduce or enhance their own. These developments have been supported by the EU’s new framework for co-ordinating FDI screening across member states.

New screening regimes add another layer of uncertainty to FDI decision making. This is just one way in which national security impacts directly on FDI, says Simon Evenett, professor of international trade and economic development at the University of St Gallen in Switzerland and the co-ordinator of Global Trade Alert, which monitors policies that are likely to affect global trade.

For some firms, especially in the technology sector, national security measures present a barrier to entry into a country, while established foreign investors can expect to be examined more closely when looking at taking over domestic firms. Firms’ current operations will also come under greater scrutiny, with questions over where they source from and who they share information with. There is an additional complication: cross-border FDI typically entails transfers of technology and, increasingly, data, both of which are now being regulated much more aggressively.

All of these factors compound the effect of national security regulation and the limits that it can place on investment opportunities. Mr Evenett notes that some countries have put in foreign FDI screening mechanisms, making it difficult for companies to invest, even when the governments of these foreign entities are allies. Over time, therefore, screening has evolved from a purportedly forensic, evidence-based process to become “much broader and more threatening to FDI than we realised,” he says.

The protectionist mood also re-enforces a growing trend towards the regionalisation of value chains. James Zhan, director of investment and enterprise at UNCTAD, expects the regionalisation trend—driven by pressure for post-pandemic resilience and regional self-reliance, as well as political tensions—to strengthen. “The policy shift of multinationals towards the regionalisation of value chains has intensified protectionism. This is more systemic because of geopolitical tension, and it will impact firms' FDI decisions,” says Mr Zhan.

Fragmentation and uncertainty

In a fast-moving FDI landscape that continues to be shaped both by the response to the pandemic and national security considerations, it’s difficult to accurately assess the consequences for the sustainability agenda.

With energy, infrastructure, water, agriculture and healthcare among the sectors subject to tighter FDI screening regimes, heightened national security concerns will inevitably impact detrimentally on investment linked to certain SDGs.This raises the possibility of investors shifting their attention away from SDG-related sectors considered strategically sensitive. More broadly, the sharpened focus on national security contributes to a fragmented global trading environment that amplifies FDI risks. And as FDI returns are low, especially in many sustainability-sensitive sectors, the sustainability agenda is likely to suffer further collateral damage.

“I'm quite sure that sophisticated multinationals thinking about putting hundreds of millions on the line are taking serious advice from law firms on the risks involved,” says Mr Evenett. “The simple fact is that these national security regimes have been designed with so much discretion given to the implementing government that it’s hard to argue that the investment regime is as predictable as it was beforehand.”