Capital outflow: Threat or catalyst for economic growth?
Whereas there has been a long-term intensive debate about the benefits and costs of significant foreign equity control of Czech businesses, much less attention is paid in the opposite direction – outgoing investment from the Czech Republic to other countries. This is true even though a significant downturn in the inflow of new strategic investment can be observed in recent years, while external surpluses and growing economic prosperity have enabled the Czech Republic to have a larger outflow of capital to other countries. This article therefore looks at two major economies that have experienced capital outflows for many years – the USA and Germany. These countries are the largest investors in foreign markets and the impact of capital outflow on domestic activity differs in the two cases. Foreign equity investments flowing from the German economy are more often motivated by the transfer of the final parts of the production chain with the aim of serving the local market. Such investments substitute for German exports and tend to suppress investment activity there. By contrast, the data indicate that US multinationals use their foreign branches mainly to produce intermediate products efficiently and they are then re-integrated into domestic production, which has more of a stimulative effect on US investment activity. In addition, the example of the German economy conflicts with classical thinking, where a current account surplus is seen as always desirable. This is because persistently high surpluses signal either excessively high savings or insufficient investment, which may indicate deeper structural problems in an economy.
Should a capital outflow raise concerns?
The impacts of significant foreign equity control of domestic businesses have long been discussed in the Czech Republic. However, the Czech Republic has been exporting more capital than it imports for more than 10 years now. Foreign capital imports were of key importance to the Czech Republic in the past. Foreign investment, which was channelled mainly into industrial production, information technology, finance and energy, helped create new jobs, technological progress, infrastructure development and the Czech Republic’s involvement in global value chains. When this trend started to recede, the focus shifted to a significant payment of the profits made by domestic companies to foreign owners. However, little attention is paid to the increasing outflow of new foreign direct investment from the Czech Republic. Moreover, looking at the entire external balance, the Czech Republic has been a net exporter of capital for more than ten years[1] (Chart 1). While this phenomenon has gone almost unnoticed in the Czech Republic, a broader debate has been going on in the European Union for some time now.
Chart 1 – External balance and foreign direct investment, annual moving sum
(as a % of GDP)
Source: CNB
Note: Foreign direct investment (FDI) only includes new equity (excluding reinvestment and debt capital). A negative external balance means an inflow of capital, a positive balance means an outflow. CA – current account, KA – capital account.
Together, the current priorities of the European Union – defence capacity, self-sufficiency, competitiveness and climate neutrality – create an unprecedented need for new investments. Challenges in the digital transformation, reform of healthcare, education and many other areas are added to these tasks. To respond to these challenges, the EU will need to find huge financial resources. European Central Bank President Christine Lagarde calculated EUR 875 bn would be needed annually just to meet the emissions targets and achieve the 2% threshold of defence expenditure. She also drew attention to the fact that this task would be less demanding if the EU managed to deal with the massive outflow of capital. “Every year there is a net outflow of EUR 250 billion, or 8% of European GDP, that goes to the rest of the world, mainly to the United States” (Pluralia, 2024). Does the outflow of capital really reduce the financial resources available for domestic investment or can such an outflow paradoxically be a catalyst for the domestic economy’s development?
In an environment of imperfect financial markets, capital outflows have a negative impact on domestic investment. According to simple intuition, the outflow of capital limits the financial resources available for the domestic economy. However, this effect is based on the key assumption of the relative scarcity of capital in the domestic economy. If capital is scarce and financial markets are imperfect, the transfer of some domestic savings abroad may reduce the availability of domestic financial resources and raise interest rates. Domestic businesses and firms may thus face worse borrowing conditions compared to the global market. This problem therefore concerns not only emerging economies, which suffer from limited capital availability, but also advanced ones, if their capital markets are underdeveloped.[2] By contrast, when the situation on financial markets approaches ideal conditions[3], the free movement of capital guarantees that new funds from abroad replace missing resources smoothly. In such a case, interest rates remain stable, as the market effectively balances the supply of and demand for capital, which ensures affordable financing for domestic firms.
In an environment of the free movement of capital, an outflow of investment may stimulate and limit the domestic economy. It depends on the motivation behind the investment itself or, in other words, where domestic entities’ investments are directed and why. The literature distinguishes three key motivations behind the expansion of firms and businesses abroad (Hejazi and Pauly, 2003). The first is the search for new markets, where the aim is to gain access to new customers and broaden the geographical reach of a business. The second motivation is the search for efficiencies, where firms try to cut costs, for example by shifting part of their production to countries with cheaper labour or more favourable regulatory conditions. The third motivation is the search for strategic products and natural resources, which includes the acquisition of key raw materials, technologies and know-how that are not available on the domestic market. The impact of the outflow of capital on domestic investment may differ even within these categories.
Whether domestic investment activity is stimulated or suppressed depends on firms’ motivation for expanding into foreign markets
The impact of foreign expansion on domestic investment depends on whether it substitutes for trade. If a firm expands into another country with the aim of covering demand there (horizontal investment[4]), the impact on domestic investment depends on whether such expansion substitutes for exports of domestic production or actually finds new customers. If foreign investment substitutes for trade in finished products, domestic production may weaken, as demand for products produced in the home country weakens. Conversely, if a firm expands in order to serve markets that were not previously served, for example due to high trade barriers or transport costs, domestic economic activity may be stimulated. The shift of part of production abroad increases the demand for domestic intermediate products and production goods that are necessary to start and support foreign operations, leading to an increase in investment in the home country. This can be understood as the creation of in-house export opportunities. In the literature, horizontal investment is often distinguished into tradable and non-tradable goods. Outflows of foreign direct investment (FDI) in services tend to have a positive impact on the domestic economy, as services are mostly non-tradable, so in the absence of FDI, the foreign market would simply not be served (Hejazi and Pauly, 2003).
Investments that complement trade tend to stimulate domestic activity. The motivation for foreign investment known as the search for efficiencies (vertical investment[5]), consists of firms’ efforts to increase profit by relocating parts of the production chain to countries with cheaper inputs. A large part of products made abroad is then imported back into the domestic economy, where these inputs are used for final production. Finished products are then exported from the domestic economy to serve foreign customers. Vertical investment thus serves as a complement to trade. As in the case of horizontal investments, the transfer of part of the production chain abroad encourages exports of intermediate products and production goods from the domestic economy. At the same time, increased labour efficiency and better resource allocation support growth in the parent company’s profitability, which frees up additional financial resources that can be used in the domestic economy. This motive therefore supports domestic investment activity.
Obtaining new technologies, knowledge and innovation from abroad strengthens the domestic economy. The third motivation for foreign investment is the attempt to obtain assets that are not ordinarily available in the domestic economy, but may be key to a firm’s long-term strategy, such as patents, know-how or natural raw materials. This type of FDI can positively affect the domestic investment environment, as access to new technologies and knowledge increases productivity, strengthens competitiveness and can contribute to the development of production in new sectors. However, those technologies and innovations are not limited to businesses directly involved in cross-border investment, but spread across the whole economy due to spillover effects.
In practice, the commonly available data do not allow us to examine in detail what is behind firms’ decisions to expand into foreign markets. It is clear from the above that the impacts of foreign expansion on domestic production and investment are ambiguous and depend on several factors. In practice, it is challenging to identify the exact motivation behind the firms’ decisions to penetrate foreign markets. In addition, individual firms decide on their own optimisation strategies. At the macroeconomic level, however, empirical procedures can be used to estimate the aggregate impact of capital outflows on the domestic economy.
While the outflow of capital from the USA stimulates domestic activity, it has long been reducing it in Germany
We will use a cointegration analysis to determine the impact of investment outflows on domestic investment activity. The ARDL model (Pesaran et al., 2001) is a suitable tool for estimating the long-run relationship between the two variables.[6] Significant capital outflows have been recorded in both the USA and Germany since the 1970s. In both cases, the results of a cointegration analysis support the hypothesis of a long-term statistically significant relationship between capital outflows and domestic investment activity in all the time periods under review.[7] This relationship is measured by a multiplier, which expresses how much domestic investment changes in the longer term as a response to a capital outflow (Chart 2). The long-term multiplier has a negative value of -1 for Germany. This means that the outflow of FDI totalling 1% of GDP in the longer run is accompanied by a decline in domestic investment of 1% of GDP as well. In the case of the United States, the long-term coefficient is positive at 2.2. This means that FDI outflows of 1% of GDP in the USA lead to an increase in domestic investment of 2.2% of GDP. Despite the strong cointegration relationship between the two variables, which persisted until 2023, the long-term multiplier in the USA gradually decreased, to the point it became statistically insignificant. This may indicate changes in the nature of outgoing investment at the start of this century. Newly outgoing capital may be ceasing to be an investment stimulus. In the case of Germany, by contrast, the long-term multiplier has remained close to -1 over the entire period monitored. The outflow of capital from Germany has thus long been accompanied by lower domestic investment activity.[8] The different impacts in the two countries under examination may be based on different motives behind foreign investment. A dataset regularly compiled by the OECD containing information on the activities of multinational enterprises (MNEs)[9] and their integration into global value chains can provide us with a better view into outgoing investments.[10]
Chart 2 – Long-term multiplier
Source: World Bank and own calculations
Note: The colour indicates the end of the sample on which the long-term multiplier was estimated. A transparent colour indicates that the long-term multiplier is insignificant.
German investors move the final parts of production, while US firms outsource the production of intermediate products
Foreign branches controlled by the USA and Germany dominate global production. Chart 3 shows the share of individual countries in the total production of all foreign-owned branches. A foreign-owned branch is a company whose owner or controlling parent company is domiciled in another country. Using the example of Germany, Volkswagen AG is a multinational domestic company and Škoda Auto is a foreign branch (the registered office is in the Czech Republic, but ownership is German). As shown by Chart 3, the share of German-owned foreign branches (e.g. Škoda Auto, Seat, BASF) in the total product of all foreign branches is slightly over 10%. This means that Germany owns companies around the world that together produce 10% of the total product of all foreign branches with various owners. Germany is not in first place, which is held by the USA, whose foreign branches produce almost a quarter of the total product of all foreign companies.
Chart 3 – Share of foreign affiliates in total production, by ownership
(as a %, 2019)
Source: OECD AMNE database
Note: It includes only the business sector (excluding public administration and defence), excluding tax havens (Ireland, Switzerland, Singapore, the Netherlands, Luxembourg and Belgium).
Looking at the relative importance of foreign branches in the domestic economy, the picture is the opposite. US foreign branches may dominate global production (Chart 3), but they play a much smaller role in the US economy – they add only 10% to the total national product[11] (Chart 4). In the case of Germany, the figure is more than 2.5 times as large.
Chart 4 – Breakdown of national product by ownership
(as a %, 2019)
Source: OECD AMNE database
Note: It includes only the business sector (excluding public administration and defence), excluding tax havens (Ireland, Switzerland, Singapore, the Netherlands, Luxembourg and Belgium).
The data indicate that Germany moves the final stages of the production chain, while the USA tends to seek foreign suppliers. In the German national product, foreign branches therefore have a higher weight compared to the USA. This may be due to a higher share of investment that goes abroad in order to serve the local market. Shifting the final stages of the production chain from Germany (e.g. moving the production of certain car models to Eastern Europe[12] or moving chemical groups to China) is leading to the relatively higher product of foreign branches, as the final value of the product produced including all inputs is registered abroad. Conversely, when different parts of the production chain move from the United States, foreign production only registers the value of the raw materials and inputs produced. These intermediate products are then exported back to the domestic economy, where the finished product is finalised (one example is the transfer of chip production to China or Taiwan, from where the chips go back to the USA, where they become part of a finished product). As the final production occurs in the domestic economy, the value of the entire final product is credited by the US company. This is confirmed by data that monitor what multinational companies import and from where they import it. In 2021, the share of intra-imports (i.e. imports in interconnected businesses) of US companies accounted for 86% of their total imports. The vast majority of what US multinationals import from abroad therefore comes from their own subsidiaries located in another country.[13]
The higher participation of Germany in horizontal investment is also supported by data that monitor the added value of domestic multinational enterprises. For the domestic economy, if higher parts of the production chain or final stages of production are moved to another country due to FDI, this means a loss of high-value-added production. In the USA, MNEs add up to 50% of their value to their products, whereas in Germany this share is only 36%. Chart 5 provides a cross-section of selected industries. It is clear that while the United States holds a high share of added value in key areas such as the production of pharmaceuticals, computers and electronics, Germany lags well behind. The biggest difference is in the production of computers and electronics – US multinational enterprises add 75% of the total product, while in Germany it is only 47%. By contrast, Germany adds a higher share in the manufacture of motor vehicles, but the difference is not very high.
Chart 5 – Share of value added by domestic multinationals to total product (selected industries)
(as a %, 2019)
Source: OECD AMNE database
Relatively, US firms target emerging markets more. Non-tradable goods account for a higher share of foreign production than in comparison with Germany. A geographical breakdown gives us another view of the different structure of cross-border investments in the United States and Germany. The share of foreign branches’ production shows us that US companies are relatively more concentrated in emerging economies, while Germany invests more in the EU and other advanced economies (Chart 6). Investment in emerging regions, such as BRIIC countries,[14] South-East Asian countries and Latin America, offers a wealth of natural resources, low production costs and higher growth potential, allowing US firms to strengthen their global competitiveness and generate additional profits that can be reinvested in the domestic economy. US companies also focus more on investments in the services sector, which are generally less tradable (and therefore tend to suppress domestic exports less), in the framework of which production is concentrated more in areas that provide higher knowledge spillover effects (information and communication, professional and scientific activities) (Chart 7).
Chart 6 – Share of production of foreign branches by region, USA (external), Germany (internal)
(as a %, 2019)
Source: OECD AMNE database
Chart 7 – Share of services in total production of foreign branches
(as a %, 2019)
Source: OECD AMNE database
Conclusion
The external balance structure in the Czech Republic has changed significantly in recent years – the inflow of new capital in the form of foreign direct investment has almost disappeared, while the interest of Czech entities in investing abroad has increased significantly. Although we do not yet have enough data to clearly assess the long-term impacts of this trend, experience from other economies can provide us with valuable insights.
Investments oriented on foreign markets can provide a benefit if they stimulate innovation, the sharing of know-how and the creation of global value chains. By contrast, redirecting key stages of production outside the home economy may undermine the added value of production and slow down the development of key sectors. This problem is particularly evident in Germany, where a high saving rate does not lead to adequate reinvestments in domestic infrastructure and other key sectors.
By Anna Drahozalová. The views expressed in this article are those of the author and do not necessarily reflect the official position of the Czech National Bank.
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Cadestin, C. et al. (2018): “Multinational enterprises and global value chains: New Insights on the trade-investment nexus”, OECD Science, Technology and Industry Working Papers, No. 2018/05, OECD Publishing, Paris. (External link)
Cadestin, C. et al. (2018): “Multinational enterprises and global value chains: the OECD analytical AMNE database”, OECD Trade Policy Papers, No. 211, OECD Publishing, Paris. (External link)
Devadas, S., Loayza, N. (2018): “When Is a Current Account Deficit Bad?”, Research & Policy Briefs, World Bank, 17 October 2018.
Desai, M. A., Foley, C. F., & Hines, J. R. (2005): “Foreign Direct Investment and the Domestic Capital Stock”, The American Economic Review, 95(2), pp. 33–38. (External link)
Dunning, J.H. (1993): “Multinational Enterprises and the Global Economy”, Addison Wesley, New York.
Feldstein, Martin S., (1995): “The Effects of Outbound Foreign Direct Investment on the Domestic Capital Stock”, NBER Chapters, in: "”The Effects of Taxation on Multinational Corporations”, pp. 43-66, National Bureau of Economic Research, Inc.
Hejazi, W., & Pauly, P. (2003): “Motivations for FDI and Domestic Capital Formation”, Journal of International Business Studies, 34(3), pp. 282–289. (External link)
Herzer, D., Schrooten, M. (2008): “Outward FDI and domestic investment in two industrialized countries”, Economics Letters, Volume 99, Issue 1, pp. 139-143, ISSN 0165-1765. (External link)
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Keywords
FDI outflow, domestic investment, cointegration
JEL Classification
F21, F41, C22
[1] Except for the one-off effect of the energy crisis in 2021 and 2022.
[2] For example, economies with large capital markets that rely on bank financing may be more sensitive to capital outflows compared to economies whose capital markets are deep. Insufficient access to capital markets, with high domestic savings being concentrated in liquid or low-income assets such as cash and bank deposits, may be another barrier on markets that are not quite perfect.
[3] A perfect financial market is a theoretical concept where all participants have complete information, there are no transaction costs or barriers to entry and resources are allocated efficiently. Capital flows freely cross borders, prices fully reflect all available information and there are no arbitrage opportunities or inefficiencies. This concept ensures an optimal allocation of resources.
v[4] Horizontal FDI in the host country focuses on the creation or acquisition of similar business activities already carried out by the investor in its home country. The aim can be not only expansion into new markets, but also a reduction in transport costs or overcoming trade barriers such as tariffs or quotas. This typically concerns consumer goods, as well as the automotive and electronics sectors.
[5] Vertical FDI includes investments in different stages of the production chain. An investor may extend activities “upwards” (the extraction of raw materials, production of inputs) or “downwards” (the finalisation of finished products, distribution, sale). The aim is to secure the sources of raw materials or components at lower cost, greater control over the production chain or optimisation of logistics and efficiency. This typically concerns the energy, mining, agriculture and logistics sectors.
[6] Unlike a traditional cointegration analysis, this approach does not require the series to be tested in advance for the same degree of integration. Time series can therefore be stationary at a level, first difference or a combination thereof. This method can also be used for small data samples. For our purposes, we use gross fixed capital formation as a dependent variable to exclude additions to inventories, which are volatile over time and react more to the current economic situation. The explanatory variable is FDI outflow based on the A/L approach. The source of the data for the two time series is the World Bank and we use data from 1970 to 2023. The method was only used for the USA, as the data are not supported for Germany. The model also incorporated several impulse dummy variables modelled by Herzer and Schrooten (2008).
[7] The Wald test f-statistic for the unrestricted error correction model (UECM) is higher than the upper limit defined in Pesaran (2001) for a 1% significance level. The Jarque Bera test, Lagrange Multiplier, ARCH and SC test confirm that the model’s residuals are normally distributed, independent over time and their dispersion is constant. In addition, an SC test was conducted to identify structural changes.
[8] The causal effect from outgoing investments is confirmed by the inclusion of residuals from a long-term equilibrium relationship in a simple ECM model, which is then subjected to the Granger causality test (Granger, 1988).
[9] A business that carries out economic activities in more than one country, either directly through its foreign branches or subsidiaries, or indirectly through contractual relationships and partnerships in global value chains, is defined as an MNE.
[10] The dataset maps out how different stages of production – from raw materials to final products – spread across countries. It monitors the involvement of businesses in international cooperation on the production of goods and services.
[11] It should be noted here that product in this sense does not correspond to the classic definition of GDP, but combines the value of products, including intermediate consumption. The word national means the goods and services produced by businesses under domestic control. They can therefore be multinational companies (whether located at home or abroad) or other domestic businesses. Other domestic businesses are firms that either do not participate in international investment or hold only minority non-controlling interests in foreign firms. Companies that produce in the territory of the relevant country, but are owned by foreign entities are therefore not included.
[12] According to the German Association of the Automotive Industry (VDA), German automakers produce only one-third of their total production in Germany.
[13] These data are not available for Germany.
[14] The BRIIC group comprises Brazil, Russia, India, Indonesia and China.