Thursday, November 28, 2013

Direct Investment Incomes and the Business Cycle in Canada

Foreign direct investment (FDI) is the building of new production facilities or the acquisition of existing businesses abroad. Most FDIs are undertaken by multinational companies (MNCs). Economic theory and several empirical studies suggest a positive relationship between FDI flows and the economic activity. For instance, both economic growth and gross domestic product (GDP) used as a proxy for the market size are reported to promote FDI. MNCs settle in countries having higher growth prospects or larger markets. There are other macroeconomic determinants of FDI such as the unit labor cost, the exchange rate, and the degree of openness to trade that I abstract from here to focus only on the GDP. My interest, particularly, is to show how the returns on FDI behave and how they relate to the cyclical fluctuations in GDP in Canada over the time period 1981:Q1-2013:Q2 (130 quarters).  

The Returns on FDI in Canada
The returns on Canadian direct investment abroad are known as direct investment income receipts and those on FDI in Canada are our direct investment income payments to the rest of the world. The direct investment incomes are made up of: interests, dividends, and reinvested earnings. The last two elements are alternative uses of firms’ profits. In Figure 1, below, I have plotted the total income receipts and payments from direct investments.


Figure 1: Direct Investment Real Incomes Receipts and Payments,
Millions of 2007 $, Canada, 1981:Q1-2013:Q2 (130 Quarters),
Source: Statistics Canada


It emerges from Figure 1 that:
  • The direct investment income receipts and payments are very volatile,
  • The direct investment income receipts and payments are highly and positively correlated.
Regarding the second observation, the correlation coefficient between the direct investments total income receipts and payments is .9. This latter result brings to mind empirical evidence Robert E Lipsey came up with in his 2000 paper titled InterpretingDeveloped Countries’ Foreign Direct Investment:
  • FDI outflows and FDI inflows are positively correlated.
Myself I found similar evidence as Robert Lipsey in my 2003 MSc dissertation, The Determinants and Impacts of Foreign Direct Investment. From my investigations, the correlation coefficient between FDI outflows and inflows in Canada was .84 between 1978:Q1 and 2001:Q4. Actually, If FDI outflows and inflows are positively correlated, there are reasons to expect the returns on both investments to be also positively correlated. 

It also appears in Figure 1 that, most of the time, the direct investment incomes Canada pays to the rest of world exceed what it receives. Since the second quarter of 2012, we have been observing a shift in this tendency.



Dividends followed by the reinvested earnings are the most important types of direct investment incomes. Dividends represent, on average, about 66 % of both income receipts and payments. As for the reinvested earnings, they represent, on average, about 29 % direct investment income receipts and about 17 % of income payments.


The Cyclical Behavior of FDI incomes
The fluctuations observed in the direct investment incomes’ quarterly series plotted in Figure 1 suggest me the idea to extract their cyclical components to see how they behave over time compared to the cyclical components of real GDP. I detrended the data using the HP-filter.  
In Figures 2 and 3 below, I have plotted in blue line the cyclical components of the various types of direct investment incomes. In each panel of these figures, the cyclical components of real GDP is superimposed in red line for comparison. 
In the table below I present the coefficient of non-determination and the cross-correlation coefficients of the cyclical components of the series. The coefficient of non-determination is the share of the fluctuations in the series that are attributed to business cycle. By business cycle, I mean fluctuations that last eight years or less.

Figure 2: Cyclical Behavior of Direct Investment Incomes, Receipts,
Millions of 2007 $, Canada, 1981:Q1-2013:Q2

Figure 3: Cyclical Behavior of Direct Investment Incomes, Payments,
Millions of 2007 $, Canada, 1981:Q1-2013:Q2

Table  Standard Deviation and Cross-Correlation with Real GDP of Various Types of Direct Investment Incomes, Canada, 1981:Q1-2013:Q2

It turns out that:
  • All the various types of direct investment incomes except the interests payments to the rest of the world are procyclical, i.e., their cyclical components are positively correlated with the cyclical component of real GDP,
  • The interests paid to the rest of the world by the foreign firms operating in Canada are acyclic,i.e., their cyclical component is uncorrelated with the cyclical component of real GDP,
  • All the various type of direct investment incomes are more volatile than the real GDP.
  • Interests are the less volatile direct investment incomes.
  • Fluctuations in direct investment incomes may lead fluctuations in real GDP.

The acyclicity of the interests paid to the rest of the world by the foreign firms operating in Canada makes sense because interest rates on money borrowed to finance long-run ventures are fixed. This also explains the less volatility observed in these series.  Except the interest received from or paid to the rest of the world, the highest cross-correlation coefficients are those between the GDP and the first lag of the variables. This suggests that the activities of MNCs may lead fluctuations in real GDP in Canada