Foreign Direct Investment

Discussion SectionFebruary 16, 2007Brian Chen

Agenda

Administrative Index cards Starbucks FDI case due Word on section participation

Review Political Economy of FDI

Concepts/Definitions Application: Chinese Corporations Law relating to wholly

foreign-owned enterprises Foreign Direct Investment

(Time permitting) Concepts/Definitions

Review

International Trade “Chicago school” economists tend to favor free trade But there are political and economic grounds to governments

to intervene to check absolute free trade These tools include:

Tariffs, subsidies, quotas, administrative policies, local content requirement, antidumping policies

Boeing v. Airbus Both received government subsidies: One direct, one indirect,

and the question is whether one form is worse than the other Also, there may be room to argue whether there are acceptable

political and economic grounds for government intervention in these industries

Chapter 8

The Political Economy of Foreign Direct Investment

Political Economy of FDI: Outline

Three Views Radical View

“Imperialist” extraction of host country wealth Implication: Always bad for the host country

Free Market Different countries have different comparative advantages; best

to allow countries to engage activities for which they do so most efficiently

Implication: Always good when countries are specializing in activities for which they have a comparative advantage

Pragmatic Nationalism Belief that FDI has costs and benefits, and whether to engage in

FDI depends on whether the benefits exceed the cost What are the costs and benefits to the host country?

Benefits Costs

FDI: Benefits to the Host Country

Resource Transfer Effects Capital

MNE invests capital in foreign markets Technology

Research supports that MNEs do transfer technology when they invest in a foreign country Management

When MNEs invest and manage in a foreign country, they often transfer management skills to the host country’s workforce

Employment Effects MNEs, by investing in foreign countries, can create employment opportunities for the

local workforce But: Acquisition vs. Greenfield Investment

Balance of Payment Effects Balance of Payment: A country’s balance-of-payment is the difference between the

payments to and receipts from other countries FDI can have beneficial and negative effects on a country’s balance of payment. We

look at the beneficial effects next Effect on Competition

Efficient functioning of markets require adequate level of competition between producers

FDI: Benefits to Host Country’s Balance of Payment

Initial Capital Inflow When a company invests in a foreign country, it

brings capital into that country Substitute for Imports

To the extent that the goods/services produced by the FDI substitute for imported goods/services, there is a positive effect on B-of-P

Inflow of payments from export of goods and services To the extent that the goods/services produced by

the FDI are exported to another country, there is a positive effect on the host country’s B-of-P

FDI: Costs to Host Countries

Adverse Effects on Competition MNEs may have “too much” power and kill off

competition Adverse Effects on Balance of Payments

After initial inflow of capital, subsequent outflow of capital from the earnings of the FDI

FDI may import inputs from abroad National Sovereignty and Autonomy

Key decisions that affect the host country’s economy may be made by a foreign parent that has no real commitment to the host country

FDI: Benefits & Costs to Home Country

Benefits Stream of income from foreign earnings FDI may import intermediate goods or inputs for production

from the home country, creating jobs MNEs may learn skills from exposure to foreign countries

Costs Balance of payment:

Initial capital outflow (but often set off by future stream of foreign earnings)

Current account suffers if FDI is to serve home market from low-cost production location

Current account suffers if FDI is a substitute for direct export Employment effects:

FDI a substitute for domestic production (e.g., Etch-A-Sketch)

Government Policy Instruments and FDI: Host Country Policies

Encouraging Inward FDI Tax concessions Low-interest loans Grants Subsidies

Restricting Inward FDI Ownership restraints

Exclusion from certain industries Why do so?

To protect national interest (defense, etc) To facilitate resource-transfer

Performance requirements Local content, exports, technology transfer, and local

participation in top management

Government Policy Instruments and FDI: Home Country Policies

Encouraging Outward FDI Insurance programs to cover major types of foreign

investment risks Special funds or banks to make government loans Political influence to persuade host countries to

relax restrictions on inbound FDI Restricting Outward FDI

Limit capital outflows Manipulate tax rules to encourage investment at

home Outright prohibition from investing in certain

countries

Chinese Law on WOFC

What type of FDI did Starbucks engage in (in Thailand)? Acquisition? Greenfield? Horizontal? Vertical? Wholly owned subsidiary? Joint Venture?

Suppose Starbucks invested in China instead, with the same facts. Does this law apply to your firm?

What are the articles of law that protect the host country? What are they trying to protect?

What are the article of law that protect the foreign investor? Why are they important to you?

How would you judge China’s WOFC law? Does it subscribe to the Radical View, the Free Market View, or the

National Pragmatism View? Why do you say so?

Chapter 7

Foreign Direct Investment

FDI: Definition

What is FDI? FDI occurs when a firm invests directly in facilities to produce

and/or market a product in a foreign country Examples:

Motorola sets up a plant in China to manufacture cell phones Starbuck purchases an existing UK firm, “British Coffee,” to sell

coffee, tea and desserts in the UK Volkswagen and two Chinese joint venture partners Shanghai

Automotive Industry Corporation (SAIC) and First Automotive Works (FAW) open their newly built gearbox plant in Shanghai "Volkswagen Transmission (Shanghai) Co. Ltd"

Alternatives to FDI Licensing; Direct Export

FDI: Forms

Forms of FDI Acquisitions

Purchase an existing company in the foreign country

Greenfield Investments Set up a new company “from the ground up” in the foreign

country

Examples: Motorola investments money in China and builds a new

plant to produce cell phones Starbucks purchases an existing UK firm “British Coffee”

and sells coffee/tea/desserts under the name “Starbucks”

FDI: Forms (II)

Forms of FDI (II) Wholly Owned Subsidiary

Occurs when the company in the foreign country is entirely controlled/owned by one single company.

Motorola’s company that manufactures cell phones in China Starbuck’s acquisition that sells coffee/tea/desserts in the

UK Joint Ventures

Occurs when two or more companies together form a new company in the host country

In the international context, usually occurs when one (or more) foreign company and one (or more) local company join to form a new company

Volkswagon + Shanghai Automotive Industry Corporation (SAIC) + First Automotive Works (FAW)

FDI: Horizontal vs. Vertical

Horizontal vs. Vertical Direct Investment Horizontal

Investment in the “same” industry as a firm operates in at home Examples:

Starbucks and its international expansion MacDonald’s and its international expansion

Vertical Investment in a downstream supplier (backward) or upstream

purchaser (forward) as compared to the business that the firm operates in its home country

Examples: Backward: Volkswagon + SAIC + FAW to produce gearbox (an

input to Volkswagon’s home operation) Forward: Less common. Volkswagon’s acquisitions of dealers

in the US (Volkswagon “sold” cars to the dealers in the US. I.e., Volkswagon sold the output of its home country operations to the US dealers that it acquired)

Why Horizontal FDI?

Transportation CostsMarket Imperfections

Impediments to exporting Impediments to Sale of Know-How

Strategic BehaviorProduct Life CycleLocation Specific Advantages

Why Vertical FDI?

Strategic BehaviorMarket Imperfections

Impediments to Know-How Investment in Specialized Assets