CIAO DATE: 11/04

The United States and Europe as Suppliers and Recipients of FDI

Robert E. Lipsey

Occasional Paper Series No. 33

National Bureau of Economic Research, City University of New York

November 11-12, 1999

European Union Studies Center

Introduction: The World Role of Foreign Direct Investment (FDI)

One of the main manifestations of "globalization" is the internationalization of production: the carrying out of production in a country by firms based in other countries. This form of international activity is closely connected with trade, the more traditional activity of producing in a firm's home country for export to other countries. However, internationalized production has grown in importance, and much of trade itself now consists of transactions internal to firms.

Internationalized production arises from foreign direct investment, or FDI. That is investment that involves some degree of control of the acquired or created foreign firm. That characteristic distinguishes FDI from portfolio investment, which is a purchase of a non-controlling financial interest, such as by a purchase of stocks or bonds in a firm or by lending to it.

Considering the extent of discussion of internationalized production, one might guess that it has become the typical organization of production and is increasing at a rapid rate. I have estimated that internationalized production was about 4&1/2 per cent of the world's total output in 1970 and that it grew to over 7&1/2 per cent by 1994 or 1995 (Lipsey, 1998a, Table 1). UNCTAD has estimated 7.8 per cent more recently. That is substantial growth, but it may not seem commensurate with the amount of discussion about it.

What about employment? From equally frail data I have estimated that multinational firm's operations outside their home countries employ perhaps 1 per cent of the world's workers. That may be a little higher than in the 1950s, but not by much.

What does it mean that the internationalized share of production so much larger than of employment? The implication is that output per worker is something like seven times as high in internationalized production than in production in general. Internationalized production operations are more capital–intensive and more efficient than output in general.

It is this last fact that accounts for much of the public interest in internationalization and in the multinational firms that carry it out. These firms are the world's leaders in moving advanced technology, taking that term very broadly, from one country to another. The comparative advantages of these firms are in various kinds of knowledge, whether from R&D, from experience in production, or from the skills of its management or other employees. Exploiting that knowledge in many countries is the way that firms maximize their returns from that knowledge. And since the ability of firms to operate internationally increases firms` return on knowledge assets, it also encourages their investment in these assets

The Growth of U.S. Direct Investment

Internationalized production, or FDI, is often associated with American firms, but it was not invented by them. In the 19th Century, when the United States lagged technologically in many industries, European firms found it profitable to exploit their superior knowledge by setting up marketing and manufacturing operations in the United States. What has been unique about the American experience has been that FDI has been the characteristic form of American investment abroad as far back as the data exist, even in the days when the United States was, on net balance, importing capital from the rest of the world. That history emphasizes that FDI, unlike portfolio investment, the purchase of foreign stocks or bonds or bank lending to foreigners, reflects primarily not the relative abundance of capital in the two countries, but the technological level of investing firms.

Not only was FDI the dominant form of U.S. outward investment, but among all the world's countries, the United States was the dominant international direct investor. In 1970, the United States was the owner of over half the world's stock of FDI. The next most important holder, the United Kingdom, accounted for 15-17 per cent, and no other country had a share of more than 6 per cent.

The major growth of internationalized production within U.S. firms took place in the 1960s and 1970s. Up to the late 1970s, the share of U.S. firms' output, employment, and fixed investment that took place outside the United States increased steadily. After that there was a substantial decline in that share, as if U.S. firms had overreached and had to retreat (Lipsey, 1995, pp.8-9).

European FDI up to 1970

While the United States was the leader in international direct investment in 1970, we are reminded by Mira Wilkins that "Multinational enterprise headquartered in Europe has a longer history than American business abroad, going back to the middle ages…" (1977, p.577). Nevertheless, all of Europe combined held less than 40 per cent of the total direct investment stock in 1967 and that share did not change in the next few years. The United Kingdom was by far the largest European investor, followed by France and Switzerland. Germany's share, after the confiscation of direct investment in the United States in two World Wars, was below 3 per cent. By 1971, however, Germany had caught up to France, beginning a recovery that put it behind only the United Kingdom by 1975. The United Kingdom, in the meantime, had begun a long decline in its role as a holder of FDI.

On the inward side, Europe was considerably more important. The United Kingdom alone had about as much inward investment as the United States in 1967 and 1971, the United Kingdom and Germany together, much more than the United States, and all of Europe was the host to several times the amount of direct investment in the United States (United Nations, 1978).

FDI Since 1970

The United States was still the dominant supplier of FDI outflows, accounting for more than half the total from all developed countries, in the early 1970s. Then the U.S. share dropped abruptly to less than 20 per cent during the 1980s (Lipsey, 1993). Europe caught up to the United States in the 1970s and far surpassed the United States in the 1980s and 1990s, at more than twice the U.S. level (Lipsey, 1999). Japan’s outflow of FDI grew as fast as Europe's, but remained relatively small, even in comparison to the size of the economies. Developing countries in Asia were larger sources of FDI than Japan in the mid-1990s, but some part of this flow was recycled investment originating elsewhere and round-trip investment originating in China and returning to China through Hong Kong, rather than genuine investment.

Where has this flow of investment been going? During the 1970s, most of it went to Europe, well over half of the world's total in the early 1970s and still about half in the late 1970s. In the 1980s, the direction of the flow suddenly shifted. The United States became the magnet for FDI from the rest of the world. After absorbing only about 15 per cent of world FDI inflows during the early 1970s, the United States became the largest single recipient of FDI inflows during the 1980s, receiving over 40 per cent of the total world flow and a little more than all of Europe combined. After that burst of investment into the United States, Europe regained its former position as the dominant recipient of FDI in the 1990s.

With the slowing of inflows into the United States in the early 1990s, a new destination for FDI came into prominence, the developing countries of Asia, primarily East Asia. This region, one of the two main groups of developing countries, had been much less important than Latin America as a recipient of FDI during the 1970s and early 1980s. It still received less than 10 per cent of the total world direct investment inflow in the early 1980s, but became as important a destination for FDI as the United States in the 1990s.

Since FDI flows cross each other in the international capital market, we may want to look at the net flows: who is supplying FDI funds to this market on net balance, and who is receiving them. That story is mostly a more stable one than that of the gross flows. Japan and Europe have been net suppliers of FDI funds to the world (negative net inflows) in every period since 1970 (Lipsey, 1999). Developing Asia and Latin America have been net recipients of these funds in every period. The United States has usually been a net supplier of FDI but switched sides in the 1980s. It became, for a time, a net recipient of FDI, particularly in the late 1980s, when the United States received more inward FDI than Developing Asia and Latin America combined.

Over the whole quarter of a century covered here, Europe, followed by Japan, and at a long distance by the United States, were the net suppliers of FDI to the world, to the extent of almost $300 billion US. The chief net recipients of these flows, to the extent of something under $200 billion US, were Developing Asia and Latin America.

The Geography of World FDI

If Europe were viewed as a single entity, as the United States is, or if it were in fact unified, its importance as a supplier and recipient of direct investment would shrink drastically, because so much of the investment stays within Europe. In 1996, within-continent sources of FDI accounted for 60 per cent or more of the inward stock in all the European countries for which such information is available in the OECD data, with one exception. In the United Kingdom, only 43 per cent of the inward stock was from Europe (Table 1). Among the European Union countries, again with the same exception, between a half and two-thirds of the inward stock originated in the EU, but only a third of the United Kingdom stock was from the European Union. Of the investment from outside Europe, almost all came from NAFTA, which means, essentially, the United States. For almost all the countries, the NAFTA share was under a quarter, but it was over 40 per cent for the United Kingdom.

Perhaps the most striking feature of the sources of inward FDI in Europe was the almost complete absence of Japan, one of the main sources of direct investment for the world as a whole. Japan was the source of almost 20 per cent of the U.S. inward stock of investment, but only 5 per cent or less of the stock in Europe.

A similar European orientation can be seen in the direction of outward direct investment from Europe. All but one of the European countries had half or more of their outward investment stocks in other European countries (Table 2). With a few exceptions, almost all the rest was in the United States. The United Kingdom was not quite as much of an outlier on the outward side as on the inward side. However, it had, in comparison with other European countries, the smallest share of its outward investment stock within Europe, the smallest share of it in the European Union, and the largest share in the United States and in non-OECD Asia.

American direct investment was concentrated in Europe, almost half of the total, and 43 per cent went to the European Union. Not surprisingly, the United States had relatively large shares of investment in Latin America. Japan's outward investment was distributed very differently, with only 18 per cent in Europe, more than a third in the United States, and almost 30 per cent in Asia.

Thus, most of direct investment from and to European countries was part of the process of tying together these countries' economies. The largest part of the rest was involved in the bilateral connection with the U.S. economy. European firms were hardly involved with Asia through this mechanism and Japanese firms were much less connected with Europe than were U.S. firms. The United Kingdom stands out as different from the rest of Europe, part of the way toward the U.S. pattern. In addition to the stronger connections to the United States than other European countries, it had stronger ties to Asia, and weaker connections to the rest of Europe.

If we take these geographical shares as representing the cumulation of mostly recent flows, and think of Europe as a unit, we have to modify the picture of Europe as outweighing all the other sources of direct investment combined. For the world outside, Europe is the largest source of direct investment, but it does not supply the majority of the flow of capital. Much of what it does supply to the outside world has gone to the United States. For Japan, the United States is more important as a location for direct investment than the whole of Europe combined. Thus the United States has strong bilateral direct investment connections with both Japan and Europe, while Japan is connected to the United States much more than to Europe and Europe in connected to the United States much more than it is to Japan and the rest of Asia.

U.S.-Europe Bilateral FDI Relationships

A Production and employment

Production by U.S. affiliates in Europe in 1996, at almost $300 billion, was more than a third larger than production in the United States by affiliates of European firms (Table 3). The United Kingdom, Germany, and France, in that order, were the leading locations for U.S. production in Europe and the leading European owners of foreign production in the United States. In these cases, the U.S.-owned production in the country was larger than the country's affiliate production in the United States. The Netherlands and Switzerland were different: they are small countries with large multinational firms (MNCs). Their firm's affiliates produced more in the United States than U.S. firms' affiliates produced in their countries.

The contrast between U.S. and European investment in each others' home territories shows up strongly in the distributions of their production by industry, presumably reflecting the comparative advantages of U.S. and European firms and also, perhaps, the relative openness of markets. Although the United States is the larger investor overall in this bilateral comparison, European affiliates are larger producers of Chemicals and Metals in the United States than U.S. firms are in Europe (Table 4). European affiliates in the United States are also larger producers in Finance, Insurance, and Real Estate (FIRE) and especially in the miscellaneous "Other Industries," where European affiliates' production in the United States is large in Retail Trade and in Transportation, Communication, and Other Public Utilities. U.S. firms' affiliates in Europe were far larger producers than European affiliates in the United States in Petroleum, Industrial machinery, Transport equipment, Wholesale trade, and Services.

For five countries that are both major European investors in the United States and major sites for U.S.-owned production in Europe, we have an industry breakdown of production, as measured by value added. The countries are France, Germany, the Netherlands, Switzerland, and the United Kingdom. These countries are responsible for 90 per cent of production in the United States by European firms' affiliates and are the locations for over 70 per cent of U.S. affiliate production in Europe.

European affiliate production in the United States, for all these five investing countries, and U.S. affiliate production in each one, are heavily concentrated in three broad industry groups. Manufacturing is by far the largest, over 40 per cent in eight out of ten of these bilateral measures (Table 5). Petroleum is the next largest, for U.S. affiliate production in Europe, and the third largest group is wholesale trade, which mainly involves the distribution of the parent firms' manufacturing and petroleum production. These three together make up over three quarters of U.S.- owned production in each of the five countries, and more than half of each country's production in the United States. However, the figure for the Netherlands is in some doubt because of the suppression of the Petroleum total in the source.

The European affiliates apparent comparative advantages in Chemicals were common to a number of countries, particularly Germany, the Netherlands, and Switzerland. The Chemicals industry contributed more than half the production of manufacturing affiliates from the Netherlands and close to half for affiliates from Switzerland and Germany. The share of Chemicals in German investment has been high historically, recovering after World War I and again after World War II from the wartime confiscation of German affiliates. There must be some technological prowess behind such resilience.

The two sides of the U.S.-Europe relationship appear more closely balanced when measured by employment. Employment in European affiliates in the United States is almost equal to employment in U.S. affiliates in Europe (Table 6). Within manufacturing, the distribution by industry is close that by output. Petroleum and Wholesale trade are larger in output than in employment, while Services and Other industries, mainly Retail trade, are much more important in employment.

Differences among industries in output per worker are presumably a reflection of differences in human and physical capital intensities. For both U.S. and European affiliates, output per worker is extremely high in Petroleum and relatively high in Wholesale trade, and low, by a large margin, in Retail trade (Table 7). If the flow of direct investment reflected mainly capital abundance in the source country and capital scarcity in the receiving country, one might expect that affiliates from the more capital abundant country would use more capital-intensive methods of production in any industry and would tend to operate in the more capital-intensive industries. However, there is little evidence of such choices among industries in the comparison of European and U.S. affiliates. European affiliates in the United States employ many more workers than U.S. affiliates in Europe in capital-intensive Chemicals and in labor-intensive Retail trade (Tables 6 and 7). Within industries, U.S. affiliates in Europe report higher output per employee than European affiliates in the United States in five out of seven manufacturing industry groups, Petroleum, to an extreme degree, and Wholesale trade. But European affiliates have higher output per worker in Transportation and, by a large margin, in Communication and other public utilities.

Another characteristic by which U.S. and European affiliates can be compared is the ratio of output to sales. The higher the ratio, the more integrated the affiliates; low ratios mean that the affiliates are producing only a small part of what they sell. They are probably in a late stage in the chain of production, and market shares exaggerate their role in a country's production.

U.S. affiliates in Europe and European affiliates in the United States are quite similar in this respect in all industries combined and in all manufacturing (Table 8). There are exceptions: in Petroleum, U.S. affiliates are much more integrated than European ones, but in Industrial machinery, and especially in Communication and other public utilities, the European affiliates in the United States produce more of what they sell than U.S. affiliates in Europe.

B. Research and development

If FDI is more about technological advantages and flows than about capital movements, that should be reflected in the firms technological activities, their size and their location. The United States was, in the mid-1950s, a somewhat heavier investor in Research and Development (R&D) in the manufacturing sector than was Europe. In the United States, expenditures on R&D were 8 per cent of production in 1994 while they were 6.6 per cent in 14 OECD countries, including the United States, Japan, Australia, and New Zealand. In each of the four OECD technology categories, from high to low technology, United States firms spent more than more than the 14-country average… Only Sweden spent more on R&D, relative to production, over 10 per cent (OECD, 1997).

Despite the relatively high R&D intensity of the United States, in comparison with Europe, U.S. majority-owned affiliates (MOFAs) in Europe were, on the whole, less R&D intensive than European affiliates in the United States (Table 9). This was the case for manufacturing as a whole and, within manufacturing, in Chemicals, Metals, and particularly in Electronics and other electrical equipment. One might speculate that in these industries, European parents considered that R&D conducted in the United States would contribute to absorbing some of the U.S. technological advantages in those areas. There was no sign of such behavior in Industrial machinery, Transport equipment, or Finance and Insurance. In all of these areas, the European affiliates were probably in subsectors of each broad industry where there were few U.S. technological leads to absorb. In Industrial machinery, the European affiliates were not important in computers. In the transport equipment sector, they were in autos, and especially in auto assembly, rather than in aircraft.

The R&D intensities of U.S. manufacturing MOFAs in Europe can be compared roughly with those of all manufacturing firms in 14 OECD countries. Affiliates are often expected to have a "branch plant mentality," simply playing low level roles in their multinational firms' worldwide division of labor. If that were the case , one would not expect them to do much R&D, since that is the type of activity that is crucial to the MNCs, often the origin and sustainer of their firm-specific technological advantages. Even if there were not an assignment of low-skill tasks to affiliates, R&D might still be a type of activity that would be kept close to headquarters, for both supervision and protection of secrets.

In the aggregate, U.S. manufacturing affiliates in Europe are about as R&D-intensive as European firms in general, to judge from the comparison with 14-country ratios (Table 10). In Foods and Chemicals, Metals, and possibly Motor vehicles, the R&D intensities seem similar. In machinery, however, and particularly in the most R&D-intensive sectors, such as Computers, Electronic and electrical machinery, Aerospace, and Scientific instruments, the U.S. affiliates, although they do substantial R&D, perform much less relative to their output than do the national firms as a group.

European manufacturing affiliates in the United States are, on average, somewhat more R&D-intensive than U.S. manufacturing firms in general (Table 11). They are also more R&D-intensive in many industry groups and industries, including Foods, Chemicals as a whole, and even Pharmaceuticals, Metals, Electronic and electrical machinery, and several other groups. They fell far short of general U.S. levels in Computers and office machinery, in Motor vehicles, perhaps because much of the investment is in assembly plants, and in Scientific instruments.

The impression of a strong emphasis on R&D in European manufacturing affiliates in the United States is reinforced by the comparisons with home levels for four individual countries in Table 12. In the case of France, for example, the U.S. affiliates were more R&D-intensive than French industry as a whole in five out of the eight industries for which comparisons are possible. The same was true for seven out of nine German industries and a slight majority of U.K. industries. Few comparisons were possible for the Netherlands. The general picture is that European firms established or acquired firms in the United States with the intention of producing technical knowledge as well as goods and services.

We do not have data on the worldwide R&D expenditures of European multinationals, but it is clear that their affiliates in the United States have not been confined to low-skill activities. The high R&D intensities of these affiliates suggests that these firms are attracted by the comparative advantage of the United States as a location for R&D, even though it is far from the firms' headquarters. European firms have been attracted to the United States not only by the size of the market, the costs of transport, or other obstacles to trade, but also by the pool of technological knowledge that can be tapped. The result is, in many sectors, a technically sophisticated group of foreign-owned operations.

Summary

The internationalization of production, arising from foreign direct investment, is one of the main manifestations of what is called "globalization," although not the only one. FDI is not primarily of importance only as a financial flow, although it is a large part of such flows. It is one of the main channels for the international transmission and diffusion of technology and other forms of knowledge and an instrument for the allocation and constant reallocation of production among the world's regions and countries.

Europeans, particularly certain countries, have at times looked on inward direct investment as an American intrusion and threat to their economic independence and their culture. It is true that FDI has been the characteristic form of foreign investment by the United States in most periods, and the United States was by far the dominant source and owner of FDI until the 1970s. All of Europe together owned less FDI than the United States in 1970.

However, in the 1970s, Europe caught up to the United States as a source of FDI outflows, and in the 1980s and 1990s Europe far surpassed the United States. During the 1980s, the United States became a magnet for FDI, absorbing flows from the rest of the world. It turned from being a major net exporter of FDI to being a major net importer, the largest destination for FDI from other countries, receiving more than all of Europe. In the 1990s, the United States returned to its more customary role as a net FDI exporter and Europe regained its former position as both the leading destination and the leading source for FDI flows.

A distinctive feature of European FDI is that most of the outward flow goes to other European countries and most of the inward flow comes from other European countries. The other major partner on both sides is the United States. The United States sends much of its outward FDI to Europe but also has major investments in Latin America and Asia, and receives a substantial amount from Asia. That is in contrast with Europe, which sends little direct investment to Asia and also receives little from Asia. European direct investment has been tying together the European economies themselves and, to a smaller extent tying them to the U.S. economy, while U.S. direct investment has been forging close ties not only with Europe but also with Asia and Latin America.

The bilateral direct investment relationship between the United States and Europe is balanced, to a surprising degree considering European fears. While U.S.-owned affiliate production in Europe in more than a third larger than European affiliate production in the United States, the European affiliate production in the United States is a larger part of total U.S. output than U.S. affiliate production in Europe is of European output. There is some specialization by industry that differs between U.S. and European FDI. European affiliate production in the United States tends to be in Chemicals, Metals, Finance, Retail Trade, and Public Utilities, while U.S. affiliate production in Europe is concentrated in Petroleum, Industrial Machinery, Wholesale Trade, and Services.

Since research and development are generally thought of as headquarters functions, or functions kept close to headquarters locations, one might expect that foreign affiliates would not play much of a role in them. In fact, U.S. affiliates in Europe are, on average, about as R&D-intensive as domestic firms in their countries. However, in some of the most R&D-intensive sectors, such as computers, the affiliates, although they spend a substantial amount on R&D, do less of it than national firms as a group.

Although the United States as a country is more R&D-intensive than Europe, one quite consistent aspect of European–owned manufacturing operations in the United States is their high R&D intensity. For each country and almost every industry, European operations in the United States are more R&D-intensive than the corresponding U.S. operations in Europe. European manufacturing affiliates in the United States are also, on average, more R&D-intensive than U.S. manufacturing firms. Even in some high-tech fields such as Pharmaceuticals and Electronic and electrical machinery, they are more R&D-intensive than domestic U.S. firms, although they far short of average U.S. levels in Computers and office machinery, Motor vehicles, and Scientific instruments. U.S. affiliates of companies based in France and Germany were, in most industries, more R&D-intensive than the same industries at home. Thus European FDI in the United States appeared to be more involved in seeking technology than U.S. FDI in Europe.

All of this suggests that in this bilateral investment relationship, not only market size, transport cost, and other obstacles to trade are drawing foreign firms, but also countries' comparative advantages as places to develop new products and processes. In particular, European firms seem to be finding the United States a favorable environment for their R&D operations. That may be because of the existence of a pool of scientifically trained research workers, or because skilled workers are more mobile in the United States than elsewhere, or perhaps because the market in the United States embraces new products and processes more readily than other markets.

Tables (PDF Format)

Table 1	Table 2	Table 3	Table 4	Table 5	Table 6
Table 7	Table 8	Table 9	Table 10	Table 11	Table 12

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