India And ASEAN Economies To Become The Next China For (Manufacturing) Foreign Direct Investment (FDI)

For 20 years, China has been the major recipient of foreign direct investment in the developing world. It has played a big part in China’s rise from poor rural backwater to economic powerhouse, but rising costs due to higher wages and the phasing out of super-preferential tax policies are pushing multinationals, mainly labor-intensive manufacturers, to relocate. And China’s neighbors -- India and Southeast Asian countries -- stand to benefit the most as they have large pools of labor and strong domestic markets.

“The Chinese monopoly on foreign direct manufacturing investment is over,” said Robert Atkinson, president of the Information Technology and Innovation Foundation. “They are still obviously in a very strong position, but you are going to see more dispersion of those kinds of investments.”

China’s foreign direct investment fell in 2012 for the first time since the height of the global financial crisis in 2009, according to figures released on Jan. 15 by China’s Ministry of Commerce. For the full year, inbound FDI registered at $111.7 billion, 3.7 percent lower than 2011.

Overall, 2012 was a bad year for global FDI. A new report released by the United Nations Conference on Trade and Development, or UNCTAD, showed that worldwide FDI inflows fell by 18 percent to an estimated $1.3 trillion, down from a revised $1.6 trillion in 2011. This was due mainly to macroeconomic fragility and policy uncertainty among investors.

“Despite an overall 7 percent decline in FDI inflows to the Association of Southeast Asian Nations, some countries in this group of economies appear to be a bright spot: preliminary data show that inflows to Cambodia, Myanmar, the Philippines, Thailand and Vietnam grew in 2012," UNCTAD said in its report.

By UNCTAD’s measure, China was still the second-largest recipient of FDI in the world after the U.S. But capital is always searching for the highest return possible.

“Although many countries can now compete with China on labor costs, it is countries elsewhere in Asia, able to take advantage of strong infrastructure and existing supply chain networks, that will be the main beneficiaries of China’s move out of low-end manufacturing,” Gareth Leather, an Asia specialist at Capital Economics, wrote in a note to clients.

According to HSBC economist Trinh Nguyen, textile investment inflows into China shrank 18.9 percent in the first three quarters of 2012, while manufacturing FDI inflows into Indonesia rose 66 percent.

The Changing Landscape

Wages in China have been rising every year by double digits over the last decade, and China has also become more selective in screening FDI projects.

“The gigantic welcome mat that the Chinese government put out in the early part of the 2000s has been pulled back, certainly somewhat,” ITIF’s Atkinson said. China used to welcome any and all FDI, but that started to change over the past couple of years. For instance, the government welcomes investments related to research and development, but it's becoming less tolerant of highly polluting industries.

“I think companies are feeling that there are other places in Asia that are more welcoming to them and are more interested in their investments,” Atkinson said.

The history of economic development over the past few decades shows that successful economies tend to start out as exporters of low-end manufactured goods. When used correctly, FDI can help lesser-developed countries get a first step on the development ladder.

Foreign direct investments to Association of Southeast Asian Nations, or ASEAN, economies are now almost equal to China’s share, at 7.6 percent versus China’s 8.1 percent, HSBC’s Nguyen said in a recent report. “With relatively better demographic growth, ASEAN economies' share of global FDI will likely rise in the coming decade,” Nguyen added.

But this is unlikely to be a seamless process: Poor road and rail networks deter foreign investment, as do tough restrictions on FDI in India and the Philippines. Indonesia and Vietnam look likely to benefit the most from a cost perspective. Thailand, with a sound business environment and a linked supply chain, is an attractive destination, but risks include politics and wage costs.

“If they want to be the next China, they should be China without all of the problems,” ITIF’s Atkinson said.

China: The Shift From Christmas Toys To iPhones

The rise in labor costs and the decline in working-age population (thanks to the harsh one-child policy that’s been around for more than 30 years) have raised questions about China’s status as the “world’s factory floor.”

“Demographics are clearly a time bomb for China, but it’s a slow fuse,” DePaul University’s Daniel Heiser said.

The EIU forecasts that China’s total working-age population will peak this year. But given that China is still in the midst of a massive urbanization drive, the urban working-age population, which is the one that’s most important to look at because it will be the labor pool that factories will draw from, will not peak for another 16 years.

Ravi Ramamurti, director of the Center for Emerging Markets at Northeastern University, believes talk about the death of China as an export powerhouse is “vastly exaggerated.”

While China has become less competitive in low-end manufacturing, it is still one of the best the places for multi-component products, such as Apple Inc.’s (Nasdaq: AAPL) iPhones, Ramamurti explained.

Victoria Lai, China analyst at the Economist Intelligence Unit (EIU), echoed Ramamurti’s view: “China is still a big manufacturing powerhouse, it’s just what it’s making, who it’s selling to, [that] will change.”

“So maybe ... [it will be known less for] the cheap Christmas toys that it used to be known for, [and instead it will be known for] more sophisticated things,” Lai said.

Meanwhile, Beijing is also trying to encourage FDI to locate inland. It fits into China’s plan to develop its inland economy, so the region can take over most low-skill manufacturing and embark on urbanization, freeing up the manufacturing centers on the coasts to do more advanced, value-added activity, thereby facilitating China’s transition to a consumption-based economic model.

Unilever Plc (NYSE: UL), Samsung Electronics Co. Ltd (KRX: 005930) and Dell Inc. (Nasdaq: DELL) have relocated their manufacturing plants and research centers inland.

India: Playing Catch-up

“For any company that has products to sell, India is a market they have to be in,” said Pepper Hamilton attorney Valerie Demont, who chairs the firm’s U.S.-India practice group. “But if you look at the Indian market with a view that you are going to invest and make a quick return, you are going to be completely wrong.”

While India has all the right ingredients to thrive -- strong demographics, a large domestic market -- many obstacles remain. Its cumbersome business environment, restrictive FDI policy and poor infrastructure can put off foreign investors.

For an aspiring economic superpower, last August’s massive electric-grid failure that left 700 million people without electricity for days badly damaged India’s reputation. And power cuts are hardly uncommon in India.

“If you think about why India doesn’t have as much manufacturing, it’s pretty straightforward,” ITIF’s Atkinson said. “The roads are terrible and the power is always going out.”

“There is huge need for infrastructure improvement, and the lack of it has been a real hamper on foreign investment in India,” Pepper Hamilton’s Demont said.

In an effort to counter criticism, Indian Prime Minister Manmohan Singh laid out ambitious infrastructure development plans in June 2012. Under the plan, $1 trillion will be invested over the next five years to revamp the country's infrastructure.

However, the lack of talent is a major issue. “When the Indian government says ‘we need to build 2,000 miles of roads today,’ the problem is, they don’t have the engineers in India to do that,” Pepper Hamilton’s Demont said.

India has an elite-based higher education institution system. The country produces very talented graduates in a couple of top universities, but as a result of that elite-based system, there is a shortage of highly educated labor.

“India’s education system is in dire need of reform,” she added.

While a lot remains to be done, reforms are gathering pace, albeit gradually.

One of the big areas of focus has been the retail sector, which has opened up significantly to more foreign investments both for single-brand and multi-brand retail.

Until now, foreign investment in single-purpose retail was allowed up to a 51 percent stake, but it’s now being increased to allow for 100 percent foreign ownership. On Jan. 23, India's foreign investment agency approved IKEA Group’s entry into the Indian market, bringing the Swedish firm closer to being the first major foreign retailer with wholly owned outlets. Ikea plans to open 25 stores, investing about $2 billion over the next 15 to 20 years.

While multi-brand retail is opening up at a 49 percent level, it's doing so under a lot of restricted conditions. This would allow retailers like Wal-Mart Stores, Inc. (NYSE: WMT) and Tesco PLC (LON: TSCO) to open shops in India.

Aside from opening up its supermarket sector to foreign firms, the Indian government decided last September to allow foreign airlines to buy stakes of up to 49 percent in local carriers, a long-awaited policy move that could provide a lifeline to the country’s debt-laden airlines. Until then, foreign carriers had been barred from such investments because the Indian government feared that the foreign companies, with their stronger finances, would take control of the Indian carriers.

Jet Airways (India) Limited (BOM: 532617) and Kingfisher Airlines Ltd (BOM: 532747) have since begun stake-sale discussions with Abu Dhabi-based Etihad Airways.

“The Indian aviation sector is where the U.S. was 20 years ago. You go through a rapid pace of expansion, and then you go through a phase of consolidation,” said Dahlman Rose analyst Helane Becker.

Meanwhile, the Indian government also raised the FDI ceiling in the insurance and pension sector from 26 percent to 49 percent.

“While China is well ahead, India is slowly but truly catching up,” Pepper Hamilton’s Demont said. “In the long run, there is value there, and India is emerging as one of the largest consumer-based countries in the world with a growing and wealthier middle-market class, which has spending power and wants to spend.”

ASEAN Economies: Rolling Out The Red Carpet

Indonesia. Indonesia’s economy has enormous promise. Already the 16th-largest economy in the world, McKinsey’s analysis shows that this dynamic archipelago has the potential to be the seventh biggest by 2030.

Unlike the many countries and regions around the world grappling with constraints on growth caused by their aging populations, Indonesia has the potential to continue to reap a demographic dividend.

Indonesia has one of the world’s youngest demographic profiles -- 60 percent of the population is below 30, and the population is growing at a rate of 2.5 million a year. The United Nations Population Division estimates that the population could reach 280 million by 2030, up from around 240 million in 2011. McKinsey expects around 70 percent of the overall population in 2030 to be of working age (between 15 and 64) and 10 percent to be below the age of 15.

This is an attractive proposition for multinationals -- a plentiful supply of relatively cheap labor and a dynamic domestic market with a rising urban middle class.

Indonesia’s manufacturing sector is experiencing the most growth in FDI, although the service sector continues to attract the majority of the investments. In the past five years, average FDI can be broken down as follows: service sector 55 percent, manufacturing 33.3 percent, and the primary sector 11.2 percent.

However, corruption remains one of the most pressing issues facing the nation. Transparency International ranks Indonesia 100th out of 182 countries for freedom from corruption. According to the Ministry of Home Affairs of Indonesia, more than one-third of all local government leaders have been involved in corruption cases. Although Indonesia has made efforts to tackle this pervasive problem, some argue that the impetus appears to have weakened in recent years.

The Philippines. The Philippines and Vietnam are two other countries with a large labor supply and market big enough to sustain robust domestic demand.

In seven years, the population of the Philippines will rise to 110 million from 96 million in 2012, according to UN projections.

While FDI is increasing from a low base, restrictive policies -- foreign ownership is limited to 40 percent for most sectors -- and an uncompetitive business environment (ranked the worst among the ASEAN economies by the World Bank) make it one of the least attractive places for investors.

Moreover, “politics suggests that reform is unlikely to take place until 2016, the year the president is due to leave office. As such, we believe FDI will only increase marginally in the Philippines,” HSBC’s Nguyen said.

Vietnam. Vietnam has the advantage of low wages and a stable political scene. Moreover, given its proximity to China, Vietnam is able to benefit from existing supply chains.

Vietnam has an export-oriented growth model, similar to China’s. It targets manufacturing FDI through policy and incentives much more aggressively than the Philippines. While its potential market size is smaller, Vietnam will also join the 100 million-club by the mid-2020s, according to HSBC’s Nguyen.

Relative to GDP, Vietnam attracts the second most FDI among ASEAN economies after Singapore. This is because its wages are the cheapest among the major ASEAN economies, and its business environment is more competitive than those of India, the Philippines and Indonesia, although it still trails significantly behind Thailand and Malaysia.

Thailand. The country’s business environment is among the most competitive among the ASEAN economies, behind only Malaysia. Links to the regional market are strong, supported by decent infrastructure, and the country's skill levels are high.

While the country is already an established manufacturing hub for Japanese investors, companies are increasingly looking for ways to diversify from risks such as politics and floods. In addition, labor costs are higher than in other ASEAN economies, although Thailand makes up for it in skill levels as well as ease of doing business, HSBC’s Nguyen said.

Coupled with this, Thailand’s working population age growth rate will begin to decline during this decade, which means that wage pressure will continue to rise, adding to the cost pressure. Therefore, Thailand is likely to concentrate on medium- to high-end manufacturing, leaving the low-end market to countries such as Vietnam and Indonesia, Nguyen added.

Malaysia. Malaysia has a relatively small population, about 29 million, which means that even with high population growth -- totaling 32 million in 2020, by UN projections -- it will not be able to compete in labor-intensive manufacturing.

In terms of growth, Malaysia is relatively wealthy and does not have the same potential for rapid expansion as Indonesia, Vietnam and the Philippines.

“This is a huge race,” ITIF’s Atkinson said. “There’s a lot of competition out there trying to attract global investment, and while the ASEAN economies are in a good position, they can’t just sit back and relax, they have to continue to work at it.

Note: Foreign direct investment can take many forms, including mergers and acquisitions, expanding production facilities or building brand new factories. The investing company may make its overseas investment either by setting up a subsidiary or associate company in the foreign country, by acquiring shares of an overseas company or through a merger or joint venture.