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Greater prominence of cities in a changing international investment panorama

Enrique Fanjul, Founding Partner at Iberglobal Consultoría de Internacionalización. September 2020

The COVID-19 crisis is causing major disruptions in international economic flows. The world had already been deglobalizing for some time, a phenomenon which is expected to intensify with the pandemic. With COVID, the future and the structure of globalization and, in particular, the role and configuration of foreign investments, face new challenges.

Forecasts point to the biggest drop in investment flows since World War II. UNCTAD’s World Investment Report forecasts a 40% drop in 2020, which would continue with a 5% drop in 2021 , to start a recovery in 2022. These forecasts must be taken with logical prudence, given the high level of uncertainty in relation to the duration and control of the pandemic.

Efficiency versus resilience

As a direct consequence of the disruptions caused by the pandemic, the security of product supplies has come to the fore. This applies to strategic products such as medicine, but also to all kinds of products that feed global value chains. The interruptions and delays in supply chains caused by the coronavirus have made supply security a priority factor.

Global value chains had experienced constant growth since the early 1990s, accounting for around 50% of world trade, but in recent years they had begun to lose steam. Various factors explain this decline. Firstly, there is protectionism. Secondly, the increase in wages and income levels in developing countries, which were destinations for relocations –and here the case of China is by far the most relevant–, has reduced the advantages of offshoring. Lastly, technological developments such as digitization, robotization, automation, artificial intelligence and 3D printing have caused the work factor to lose relevance in production processes.

The decline of global value chains has a negative impact on foreign investment flows: fewer relocations mean less investment.

New safety valuations can also have a considerable impact. Companies are going to increase the risk assessment of depending on supplies from geographically remote locations for their inputs. The upheavals that we are currently seeing in production processes, which in certain cases have led to their total stoppage due to the interruption in the supply of essential components, constitute a very clear call of attention to these risks.

Flows of intermediate goods can be affected by a pandemic like the current one, but  other phenomena such as wars, natural catastrophes, etc. can also have an impact

In the past, offshoring decisions were based on economic reasons, mainly cost reductions. Now, national security, public health and geopolitical considerations are coming into play. These changes will have a negative effect on many developing countries, reducing their possibilities for industrial development through integration into global value chains.

The desirability of reducing dependence on supplies manufactured in remote locations may give new strength to some trends in foreign investment that have already been taking place for some time. On the one hand, the reshoring of productive activities that had been relocated in the past. Protectionism and narrowing wage differentials had already driven this trend.

On the other hand, the increasing importance of proximity production means that production centers are not necessarily located in the same country, they can be situated in neighboring countries.

Government interventionism is increasing

Another important feature of recent times is that government interventionism is increasing notably. This is due, first of all, to the rise of protectionism and economic nationalism. Secondly, interventionism is growing for strategic security reasons. Regarding foreign investment, in many countries awareness of the need to maintain control over strategic sectors is increasing, thus limiting openness to foreign investment.

Last year the European Union launched a mechanism for screening foreign investments of this type. In Spain, among the measures taken due to the coronavirus, there is a reinforcement of controls on foreign investment. The objective is to maintain a certain degree of control over strategic sectors and companies. In addition, the economic crisis caused by the coronavirus has caused a general drop in the value of companies. The idea is to limit the extent that this can be used by other countries to acquire national companies

The new EU mechanism is not designed in theory for any specific country, but it is clear that it is the Chinese investment boom what is behind its creation. The acquisition by Chinese companies of advanced technology companies that are sensitive to national security and defense in critical infrastructure sectors has raised alarms.

It is not only that companies in a particular country are buying up major European companies. China’s political and economic characteristics add an important nuance. It is a country with a very different political regime from that of European countries, many of its investment companies are state-owned companies, which benefit from a series of advantages from their Administration, primarily financial. Even private companies in China are not like private companies in other countries, in fact they have a close relationship with political power.

We are thus moving towards a future in which foreign investments will be the object of greater scrutiny. Investments will continue to be desired and cultivated, but at the same time, their economic and political implications, the nature of the investors (in particular if they are state-owned companies and, in this case, the nature of the political system of their countries) and the need to maintain control over critical sectors for the future of the economy will be even more relevant than before.

Cities to the fore

Large cities, metropolises, are becoming key elements of reference when making investment location decisions. Many investors do not begin their decision-making process at the country level. Many begin by choosing a region, and more and more are guiding their decision towards choosing a specific city. In particular, investors in the technology sectors are the most likely to base their decision-making process at the regional or city level.

What are the key factors that investors consider when evaluating a city? The most relevant is economic performance, followed by labor costs, market size, talent availability, and security and crime.

What factors can explain the growing relevance of the city as an actor of internationalization?

A fundamental factor is the structural changes in the economy and, especially, the growth of the services sector. For services, the physical space is a secondary element. For industries, on the other hand, physical space is paramount. Few industries are established within cities. On the contrary, companies in the service sector, such as technology, financial and professional services companies, are established in urban centers.

The key point in the role of cities (and their metropolitan areas) in internationalization is what could be called the “concentration effect”: cities tend to concentrate resources, knowledge, companies, institutions and services.

The first factor to consider in this regard is availability of talent. Having talent nearby as well as the entire ecosystem related to it (universities, business schools, research centers) is a critical factor when deciding where to settle.

Directly related to talent is quality of life. A city with a good quality of life has a greater capacity to attract and retain talent.

A third element which makes cities more attractive is the possibilities offered by networking, nurturing contacts and building synergies with other companies, as well as the availability of professional services. Here also the spatial frame of reference is the city in which the company is established, not so much the region or the country.

International connectivity is a fourth element. There is no doubt that, in the case of Spain, Madrid, for example, offers clear advantages thanks to its air connections with Latin America and its communications by various routes with the rest of Europe and North Africa.

Finally, having good digital infrastructures is essential in certain sectors nowadays, and these infrastructures are very developed in urban areas. Madrid also offers very favorable conditions in this regard.

The growing role of cities has led municipal governments to pay increasing attention to international promotional activities. Among them, a prominent place corresponds to attracting foreign investment. The creation of Madrid Investment Attraction and its growing impact in this area is a good example of this.