Foreign Direct Investment and Research and Development in Canada

Why do firms settle subsidiaries abroad? Many theories have been put forth to explain this phenomenon known as foreign direct investment (FDI). According to some of these theories, firms invest abroad because they possess some product differentiation ability, a monopoly power, patents, trademarks, etc... These special assets are known to be the outcomes of successful research and development (R&D) activities. I then propose to test empirically these theories by checking whether there is a long-run equilibrium relationship between Canadian direct investment abroad and our gross domestic R&D expenditure. The R&D expenditure I consider are those in National Science and Engineering funded and performed the Canadian business enterprise sector. I use, in turn, three series on Canadian direct investment abroad: (1) the net flows, i.e., the investments abroad by Canadian firms minus their divestments, (2) the outflows, i.e., the investments abroad net of the reinvested earnings, and (3) the earnings made abroad and reinvested abroad by Canadian firms. These series are plotted in the figure below for the period 1970-2011.  

The figure shows a co-movement between each of the three measures of Canadian direct investment abroad and the R&D expenditure. By co-movement, I mean when the R&D expenditure goes up or down, the measures of Canadian direct investment abroad also follow the movement. Some simple linear regression exercises indicate that the R&D expenditure explains respectively 59 % and 64 % of the variability observed in the net flows and the outflows of Canadian direct investment abroad. It accounts for 74 % of the variability observed in outflows of Canadian firms’ reinvested earnings abroad. The relationship between each of the three measures of Canadian direct investment abroad and R&D expenditure also turns out to be a long-run equilibrium one.

R&D activities generate what is called knowledge spillover, i.e., any firm can freely use the knowledge underlying previous innovations to devise new and distinct products or idea.  So, foreign firms may want to settle in Canada in order to benefit from the know-how of our domestic firms. I have found that the  flows of FDI in Canada are also positively correlated with our gross domestic expenditure on R&D. This latter variable explains respectively 31 % and 49 % of the net flows and the inflows of FDI in Canada. It explains 72 % of the profits reinvested by foreign firms in Canada. It is also worthwhile recalling here the positive correlation between Canadian direct invest abroad and FDI in Canada I mentioned in my November 28, 2013’s blog. The correlation coefficient between these two variables is about .8.                       

 

To finish with, note that:

• A reason why Canadian firms go abroad is because they are endowed with a specific know-how acquired through R&D, 
• A government policy aiming at encouraging R&D activities in Canada will boost growth, enhance the performance of our firms outside the country, and will attract more FDI in our country.

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.