How Digitalization and Globalization have Remapped the Global


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How Digitalization and Globalization have Remapped the Global FDI Network
Thomas Elkjaer and Jannick Damgaard
Paper prepared for the 16th Conference of IAOS OECD Headquarters, Paris, France, 19–21 September 2018 Session 1.C1.C., Day 1Wednesday, 19/09, 11:00-13:00: General issues related to dealing with globalization

Thomas Elkjaer [email protected] International Monetary Fund Jannick Damgaard [email protected] Danmarks Nationalbank
How Digitalization and Globalization have Remapped the Global FDI Network DRAFT VERSION 08/30/2018
Prepared for the 16th Conference of the International Association of Official Statisticians (IAOS) OECD Headquarters, Paris, France, 19–21 September 2018
Note: This Working Paper should not be reported as representing the views of the International Monetary Fund or Danmarks Nationalbank. The views expressed are
those of the authors.

ABSTRACT Digitalization and globalization affect multinational enterprises’ location and investment decisions. Digitalization is often associated with heavy reliance on intangible assets and enables the widespread use of special purpose entities (SPEs) in low-tax economies, thereby masking the patterns of real economic integration between countries. To address the decoupling in foreign direct investment (FDI), a unique global FDI network is estimated: SPEs are removed and FDI positions are broken down by the ultimate investing economy, making the network less sensitive to financial engineering. Total inward FDI is reduced by one-third in the new network, and financial centers become significantly less dominant.
Keywords: FDI, multinational enterprises, special purpose entities, financial globalization, digitalization, network, macroeconomic statistics

1. INTRODUCTION1
Foreign direct investment (FDI) is a key link in global economic interconnectedness and is widely used to analyze globalization, attractiveness of an economy, long-term relationships between economies, technology transfer, and real economic activity generated by foreign companies. Digitalization of the economy can be seen as the use of internet-based digital technologies for R&D, production, and delivery of goods and services. Since digitalization is globalizing economies and makes economic relationships borderless, traditional macroeconomic statistics that aim to measure the footprint of the national economy are being challenged. For instance, digitalization allows multinational enterprises (MNEs) to place patents in and sell digital services from offshore financial centers. These centers dominate global FDI: the Netherlands and Luxembourg are the world’s largest recipients of FDI, and are also ranked in the global top three for outward FDI along with the United States (US). Five of the top 10 FDI receiving economies appear on various lists of low-tax economies.
This paper looks at FDI as a proxy for MNE presence and illustrates how digitalization, globalization, and taxation have remapped the global FDI network. FDI is often understood as long-term strategic investments, where location decisions are driven by market or resource access. However, in today's digital economy, where intangibles are very important, these location decisions are often driven by other considerations, notably taxation. These new drivers lead to a decoupling between FDI and real economic activity.
FDI includes all cross-border investments between enterprises in an FDI relationship, where a company owns at least 10 percent of the equity in another company directly or through a chain of subsidiaries. The 10 percent ownership share is the threshold set to capture long-term strategic and stable investments in macroeconomic statistics. However, this standard measure of FDI is geographically decoupled in three main ways. First, bilateral asymmetries between inward and corresponding outward FDI positions exist for most economy pairs in the published data. For instance, in the IMF’s Coordinated Direct Investment Survey (CDIS) for end-2015, one economy's FDI is at least twice as high as the counterpart economy’s mirror estimate for 44 percent of the economy pairs and at least 10 times higher for 10 percent of the pairs (Annex I).
Second, some smaller economies are very important for global FDI, suggesting a decoupling between FDI and real economic activity. How can small economies be so dominant in global FDI? Essentially, FDI is a measure of purely financial investments that may or may not be a good proxy for “brick and mortar” investments. Some economies host many foreign-owned special purpose entities (SPEs), which typically focus on group financing or holding activities (e.g., financial assets, intellectual property rights, or other intangibles) and do not nessecarily reflect stable investment motives. While SPEs have no or very limited real economic activity in the economy they are domiciled in, they can significantly inflate FDI. Digitalization has enabled MNEs’ widespread use of SPEs since these empty shells can easily be set up in foreign countries with the assistance of non-resident tax lawyers through digital channels.
1 This paper relies heavily on Damgaard and Elkjaer (2017).

Third, as MNEs often carry out FDI through complex ownership chains, the immediate counterpart economy may not be the economy of the ultimate owner who carries the risks and benefits, or the investments’ end destination. Financial centers that typically host SPEs are much less important as ultimate FDI economies, reflecting the transitory nature of investments flowing through these centers. FDI has traditionally been broken down by the immediate counterpart economy, which provides a good measure for direct exposures, but lacks information about the ultimate investing economy (UIE). To close this data gap, OECD countries are now encouraged to also break down inward FDI by the UIE.
This paper remaps FDI positions for 116 economies into a new global FDI network, where SPEs are removed and FDI positions are broken down by the UIE. The new unique FDI network provides a clearer picture of real economic integration and ultimate financial linkages than current available data and thus offers new insights into globalization. In the new global FDI network, global FDI is reduced by one-third, financial centers are much less dominating, and traditional industralized economies become more important.
The paper is organized as follows. The roles of digitalization and SPEs in FDI are discussed in Sections 2 and 3, respectively. Section 4 compares FDI broken down by the immediate counterpart economy and the UIE, while Section 5 estimates and analyzes the new global FDI network. Section 6 summarizes the key conclusions.
2. THE ROLE OF DIGITALIZATION
Digitalization is transformative, and is a strong driver of globalization. Digitalization — the use of digital technologies, such as the internet and smart phones, in everyday life — has made the access and process of information more reliable, timely, and accurate. It is a global phenomenon: Worldwide internet users have tripled since 2005, and with 3.2 billion users in developing countries at the end of 2015, more now have access to digital technology than to secondary school or clean water (World Bank, 2016). On the business side, the emergence of digital business is also a global force. Businesses use internet-based digital technologies for R&D, production, and delivery of goods and services. According to the IMF (2018a), the digital sector – i.e., producers of ICT goods and services, online platforms, and platform-enabled services – still accounts for less than 10 percent of value added, income, and employment in most economies. However, digitalization has penetrated many activities, and almost all activities could be included in a broader definition of the digital economy.
Digitalization is also transforming global finance. Digital fundraiser platforms, such as Kickstarter, create new financial market platforms and allow for more direct financing, including cross-border, without traditional intermediation. Moreover, blockchain with its decentralized distributed digital ledger can challenge traditional financing by making cross-border financing quicker, cheaper, and more secure. These digital drivers of global finance are starting to challenge the monopoly of traditional intermediaries, including banks, to provide international finance (McKinsey, 2017).
Since digitalization is globalizing economies and makes economic relationships borderless, traditional macroeconomic statistics that aim to measure the footprint of the national economy based on physical presence are being challenged. Much analytical work has already been done on the challenges that

global value chains present when allocating income to different economies along the production chain (e.g., Timmer, Azeez Erumban, Los, Stehrer, and Vries, 2014). However, digitalization also makes it difficult to geographically connect investments and separate real financial integration and diversification from financial engineering in macroeconomic statistics.
In particular, since digitalization is often associated with heavy reliance on intangible assets, enabling little or no physical presence, it can be difficult to make precise valuations of investments in the national economies. Intangibles used by digital companies include, for example, algorithms to process data and to generate value through personalized advertising. From a funding point of view, valuation uncertainties may also make it challenging for companies that rely heavily on intangibles to raise funds through initial public offerings (IPOs) because it is difficult for outsiders to make reliable appraisals. For instance, in the US Generally Accepted Accounting Principles (GAAP), own R&D expenses are deducted from profits and are generally not capitalized (do not build assets and thereby own equity), whereas intangibles bought via acquisitions can be added as assets.
FDI equity mainly consists of unlisted equity, for which no market prices exist and therefore fair valuations are estimated. Damgaard and Elkjaer (2014) show that choice of valuation method can have a significant impact on FDI data (Figure 1). Using Danish micro level company data, they also find that unlisted FDI equity liabilities vary from 22 to 156 percent of GDP when applying different estimation techniques, but just one fair valuation method, price to earnings. While the most common FDI valuation method, own funds at book value, promotes cross-economy comparability, it does not necessarily lead to current market-value approximations if companies value their assets and liabilities at outdated historical costs.
The use of intangibles and valuation challenges are not limited to tech companies. IMF (2018b) finds that some other sectors, such as pharmaceuticals, also use intangibles intensively, and tech companies are just slightly more dependent on intangibles than the average US Fortune 500 company. In addition, digitalization is not only associated with large companies in advanced economies. Small companies can become “micro-multinationals” by using digital platforms, like Amazon or Alibaba, to connect to customers and suppliers worldwide. Also, going forward, the developing world is expected to play a large role globally. By 2025, emerging economies are expected to host almost 230 companies in the Global Fortune 500, up from 85 in 2010 (McKinsey, 2016).
Doidge, Kahle, Karolyi, and Stulz (2018) find that publicly listed companies in the US are becoming older and larger while profits are more concentrated. According to Crouzet and Eberly (2018), this rising concentration can primarily be attributed to increased market shares of the most productive firms in the consumer sector, partly due to scalability of intangibles, and to market power (measured by markups) in the healthcare sector. Even if these issues related to digitalization and globalization are not new, at least digitalization seems to reinforce existing challenges because sheer scale is putting so much pressure on current international statistical methodological arrangements as to require fundamental changes to better measure activities. These measurement uncertainties can lead to important misunderstandings and affect policy recommendations, thus pointing to the need for further international harmonization and exchange of data.

Figure 1. Effect of Using Different FDI Valuation Methods
Source: Damgaard and Elkjaer (2014). Note: Data for end-2006 based on official FDI statistics for OECD countries. Denmark* represents the official Danish FDI statistics where own funds at book value is used for the valuation of unlisted equity. Denmark** represents price-book value estimates, while Denmark*** represents price-earnings estimates with the exclusion of negative positions. 3. THE ROLE OF SPES The decoupling between FDI and real economic activity is growing as corporate structures and financing mechanisms become more digitalized and global. Even though FDI measures financial investments, it is traditionally used as a proxy for real economic activity generated by foreign-owned companies and long-term relations between economies. However, with increasingly complex and flexible MNE structures and widespread use of SPEs, FDI may be a less useful indicator for real activity, long-term relations between economies, or even for stable external financing. SPEs break the direct link between the receiving economy and the ultimate owner, and “inflate” FDI because they have large gross foreign positions but very small net foreign positions, reflecting their role as pure financial intermediaries rather than final investment targets. Consequently, SPEs make it difficult to separate real financial integration and diversification from financial engineering. While there is no uniform international definition of SPEs, statistical manuals provide similar criteria for identifying an SPE. These include: formally registered legal entity that is subject to national law, ultimate owners are not residents of the territory of incorporation, few or no employees, little or no production in the host economy, little or no physical presence, most assets and liabilities are vis-à-vis

non-residents, and the core business of the enterprise consists of group financing or holding activities (OECD, 2008).
FDI financing through SPEs is often only transitory. For instance, Blanchard and Acalin (2016) find a high positive correlation between quarterly FDI inflows and outflows in several economies, suggesting that FDI inflows are often just passing through an economy on the way to their final destination. Moreover, Lane and Milesi-Ferretti (2017) find that FDI positions, unlike positions in portfolio investment and other investment, have continued to expand in the aftermath of the financial crisis. This increase primarily stems from FDI positions vis-à-vis financial centers and can be attributed to the growing complexity of the corporate structures of large MNEs.
Tax, regulatory, and confidentiality benefits – utilized through SPEs that are typically set up in offshore financial centers – drive much of the expansion in FDI. These benefits are potentially large, for instance for the US the annual tax revenue loss from offshore tax exploitations is estimated to be around USD 100 billion (U.S. Senate Permanent Subcommittee on Investigations, 2008). Therefore, both SPE funding and location are likely less stable than for other types of FDI because even small legislative changes – domestically or abroad – can significantly shift investment patterns and lead to capital outflows. Table 1 provides an overview of the 50 economies, mostly Caribbean and European, appearing on various low-tax economy lists.
Table 1. List of Low-Tax Economies

Asia: Caribbean:
Central America: Eastern Africa: Europe:
Northern America: Middle East: Oceania: Western Africa:

Hong Kong SAR, Macao SAR, Maldives, Singapore Anguilla, Antigua and Barbuda, Aruba, Bahamas, Barbados, British Virgin Islands, Cayman Islands, Dominica, Grenada, Montserrat, Netherlands Antilles, St. Kitts and Nevis, St. Lucia, St. Vincent and Grenadines, Turks and Caicos Islands, U.S. Virgin Islands Belize, Costa Rica, Panama
Mauritius, Seychelles
Andorra, Cyprus, Gibraltar, Guernsey, Ireland, Isle of Man, Jersey, Latvia, Liechtenstein, Luxembourg, Malta, Monaco, San Marino, Switzerland
Bermuda
Bahrain, Jordan, Lebanon
Cook Islands, Marshall Islands, Nauru, Niue, Samoa, Vanuatu Liberia

Source: Government Accountability Office (2008).
Note: Includes economies that appeared in at least one of the following lists: (1) OECD's list of committed jurisdictions and uncooperative tax havens (no jurisdictions have been included in this list since 2009), (2) the tax haven list by Dharmapala and Hines (2006), and (3) the IRS list of offshore haven or financial privacy jurisdictions. Economies in bold report to the CDIS.

FDI has become more responsive to taxation over time (OECD, 2007). MNEs can optimize taxes through SPEs or regular operating units, and tax optimization often involves shifting profits to a low-tax jurisdiction through debt allocation, transfer pricing, or corporate inversions. For example, MNEs may allocate most of their debt to a high-tax economy to take advantage of high interest deductions while shifting profits to low-tax jurisdictions.
Moreover, MNEs can use distorted transfer pricing to shift profits to low-tax jurisdictions through sales of goods and services between affiliates. Such practices can substantially affect FDI through profits and retained earnings. In principle, the transfer pricing should be at arm's-length prices, but it can be very difficult for tax authorities to determine if a fair price has been used for transfers of intellectual property rights and intangibles. For the US, intra-group trade in goods accounts for 48 percent of total imports and 30 percent of exports, and 22 and 26 percent of services imports and exports, respectively (Lanz and Miroudot, 2011). In a string of high-profile cases, the European Commission has ruled that the tax authorities in Ireland, Luxembourg, and the Netherlands have allowed Apple, Fiat, and Starbucks to use transfer prices that do not reflect underlying economic prices. This practice was found to violate EU state aid rules, and the three countries have been instructed to collect significant additional taxes from the companies involved, but the countries disagreed with the rulings and subsequently appealed them.
Finally, international corporate structures can be used to shift profits away from high-tax jurisdictions. Recently, some US-based MNEs have been involved in corporate inversions, where the parent company’s headquarter is moved abroad to a low-tax jurisdiction through a merger with a foreign company, effectively changing the domicile of the parent company but not providing new actual FDI funding. While such MNE corporate structures may not technically meet the SPE criteria, they still function to some extent as near-SPE structures and can contribute to the geographical decoupling in FDI, see for instance Lane and Milesi-Ferretti (2017) for an analysis of FDI in Ireland. This practice has also had a significant impact on Irish GDP data (OECD, 2016). Near-SPEs may become more common with the implementation of the principles of the G-20/OECD Base Erosion and Profit Shifting (BEPS) Project because MNEs will need to have more presence in low-tax jurisdictions to be able to claim permanent establishment and have taxable presence in such jurisdictions.
Globally, the largest recipients of FDI in absolute terms include major economies like the US, China (Mainland), United Kingdom, Germany, and France, but also smaller economies such as the Netherlands, Luxembourg, Hong Kong SAR, Singapore, Ireland, and Switzerland (Figure 2). All economies in the latter group host financial centers, and a large share of the high FDI in these economies can most likely be attributed to SPE presence.
The top recipient economies change somewhat when looking at FDI intensity, measured as inward FDI-to-GDP. Luxembourg is now the largest recipients by a wide margin, followed by Mauritius, Malta, and Cyprus, which are all included in the list of low-tax economies (Table 1). The Netherlands, Hong Kong SAR, Ireland, Singapore, and Switzerland remain near the top whereas the major economies are no longer present. More economies appearing on the list of low-tax economies are likely to be top recipients of FDI in relative terms, but only economies that report to the CDIS are

included in Figure 2, and many offshore financial centers, e.g., British Virgin Islands and Cayman Islands, do not report to the CDIS.
SPEs have no or very limited real economic activity in the economy they are domiciled in, but can have significant FDI, essentially “inflating” the FDI numbers. Most OECD countries report FDI data including and excluding SPEs separately to the OECD while the CDIS does not currently include such a breakdown. Economies that host SPEs tend to have high FDI-to-GDP ratios. For Luxembourg, the inward FDI position excluding SPEs is 393 percent of GDP, compared to 5,658 percent when SPEs are included (Annex II). The large non-SPE FDI in Luxembourg largely reflects investments in the financial sector. For the Netherlands, the corresponding numbers are 97 percent and 525 percent.

Figure 2. Top 20 Inward FDI Economies

6,000
Netherlands* Luxembourg* United States China, P.R.: Mainland United Kingdom China, P.R.: Hong Kong*
Singapore* Ireland*
Switzerland* Germany France Canada Spain Australia Mexico Brazil Belgium* Italy India Sweden

5,000

Percentage of GDP

4,000

3,000

2,000

1,000

0
Luxembourg Mauritius Malta Cyprus Netherlands China, P.R.: Hong Kong Ireland Singapore Mozambique Hungary Aruba Mongolia Switzerland Palau Barbados Montenegro Georgia Cabo Verde Belgium Bahrain, Kingdom of

0

1,000

2,000

3,000

4,000

5,000

6,000

USD billions

Inward FDI (USD billions) Inward FDI (percentage of GDP)

Source: IMF (CDIS and World Economic Outlook Database). Note: End-2015 inward FDI positions published with the initial release of the 2015 CDIS in December 2016 and GDP for 2015 from the October 2016 World Economic Outlook Database. In the few cases where data for 2015 are not available, latest available data are used. Economies with an asterisk are in both top 20 lists.

4. FDI BY ULTIMATE INVESTING ECONOMY
FDI by the UIE, i.e., the economy of the ultimate controlling parent, provides important insights into the underlying interconnectedness between economies, including real economic interpendencies and ultimate financial benefits and risks incurred by the ultimate investors.
There is a strong push for more comprehensive data on cross-border exposures and “ultimate risk,” including in the report The Financial Crisis and Information Gaps by the IMF and Financial Stability

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How Digitalization and Globalization have Remapped the Global