CH 7 Foreign Direct Investment

Importance of FDI in world economy Theories used to explain FDI Government policy towards FDI

FDI Terms FDI = firm invests directly in facilities to

produce and/or market a product in a foreign country Green-field investment = establishment of a

new operation Acquiring or merging with an existing firm

Multinational Enterprise = firm that owns business operations in more than one country

FDI Terms

Flow of FDI = amount of foreign direct investment undertake over given period FDI outflows = FDI flow out of a country FDI inflows = FDI flow into a country

Stock of FDI = total accumulated value of foreign owned assets at a given time

Growth of FDI Firms fear protectionist pressures

Way of circumventing future trade barriers

Political and economic changes – shift toward democratic political institutions and free market economies

Globalization of the world economy

Drivers of FDI To get access to national markets

Establish low cost manufacturing locations from which to serve regional or global markets

Important to have production facilities based close to their major customers

Direction of FDI

Historically directed at the developed nations

US was largest recipient because Large and wealthy domestic market Stable economy Favorable political environment Openness to FDI

Direction of FDI Recent inflow targeted into

developing nations – emerging economies Asia, especially China Latin America

Inability of Africa to attract FDI Political unrest, armed conflict Frequent changes in economic policy

Source of FDI 60% of all FDI outflows 1997-2002

US has been the largest source country UK, Netherlands, France, Germany, Japan

2002 – 100 largest multinationals 26% US 17% Japanese 12% French 12% German 10% British

Form of FDI Majority of cross-border investments in the form

of mergers & acquisitions rather than green-field Developed nations 2/3 M&A Developing nations 1/3 M&A

Why M&A Quicker and easier to execute than Green-field Acquire valuable strategic assets – brand loyalty,

customer relations, trademarks & patents, distribution systems, production systems, etc.

Increase efficiency of acquired unit by transferring capital, technology or management skills

Theories of FDI

Why FDI when could export or license

Why firms in same industry undertake FDI at same time & why certain locations are favored as targets

Eclectic paradigm – combine the two

Alternative to FDI Exporting

Producing good at home and shipping to receiving country for sale

Limitations- viability is often constrained by transportation costs – unprofitable to ship

some products over large distances trade barriers – import tariffs or quotas

Alternative to FDI Licensing

Granting a foreign licensee the right to produce & sell the firm’s products in return for a royalty fee on every unit

Limitations – Internalization theory Give away valuable technological know-how to

potential foreign competitor Lack of control over manufacturing, marketing &

strategy required to maximize profitability Firm’s competitive advantage may be based not on

product, but on marketing, management or manufacturing process capabilities

FDI best entry strategy when Firm has valuable know-how that cannot

be adequately protected by a licensing contract

Firm needs tight control over a foreign entity to maximize its market share and earnings in that country

Firm’s skills and know-how are not amenable to licensing

Pattern of FDI Knickerbocker - Mulitpoint competition Firms in the same industry often undertake FDI

at same time Clear tendency to direct FDI toward certain

locations

Reflection of strategic rivalry of competitors Oligopoly – interdependence of major players Firms tend to imitate each other’s FDI Match each other’s moves to hold each other in

check

Pattern of FDI Raymond Vernon - Product Life cycle

Firms undertake FDI at particular stages in the life cycle of a product that they have pioneered in their home market

Invest in other countries when local demand is large enough to support local production

Shift production to developing countries when product standardization and market saturation give rise to price competition and cost pressure.

Eclectic Paradigm British economist John Dunning

In addition to theories of patterns of trade -Location specific advantages important in explaining rationale for and direction of FDI

Combining location specific assets or resource endowments & the firm’s own unique technological or management capabilities often requires FDI

Political Ideology & FDI Radical view - MNE is instrument of

imperialist domination Exploit host country for benefit of home

country Keeps developing countries backward &

dependent on capitalist nations for investment, jobs & technology

Extract profits & give nothing of value to host country

Important jobs go to home country nationals

Political Ideology & FDI Free Market View – Adam Smith &

David Ricardo

Theory of comparative advantage Countries should specialize in the

production of those goods & services they can produce most efficiently

MNE is instrument for dispersing production to the most efficient locations around the globe

FDI resource transfers benefit the host country & stimulate its economic growth

Political Ideology & FDI Pragmatic Nationalism – FDI has

both benefits & costs

Benefit a host country with capital, skills, technology, & jobs

Costs to host country in terms of repatriation of profits and importing of components

FDI should be allowed if the benefits outweigh the costs

FDI Benefits Host Country Resource transfer effects

Supplying capital, technology & management resources

Employment effects Brings jobs directly by MNE employing & indirectly by suppliers

employing MNE tend to pay higher wages

Balance of payment effects Tracks payments to & receipts from other countries FDI can substitute for imports, & can export to other countries

Effects on competition & economic growth Green-field increases the number of players, increase competition Competition drive down prices & benefit consumers Increased productivity, innovation & economic growth

FDI CostsHost Country Adverse effects on competition

MNE subsidiaries may have greater economic power than indigenous firms

Adverse effects on balance of payments Too much outflow so restrict the amount that can be

repatriated Too much importing of components vs local sourcing

Perceived loss of national sovereignty Key decisions that effect host economy will be made

by foreign parent with no commitment to & no control by host country

FDI Benefits Home Country Inward flow of foreign earnings

May also create demand for home country exports of equipment & goods

Employment effects Jobs created by demand for exports

MNE learns valuable skills that can be transferred back reverse resource-transfer contributing to

home country economic growth rate

FDI CostsHome Country Balance of payments

Suffers from initial capital outflow to finance FDI Suffers if purpose to supply home market from

low-cost production location Suffers if the FDI is substitute for direct exports

Employment effects Suffers when FDI is substitute for domestic

production – reduced home country employment

FDI & Government PolicyHome CountryPolicies for encouraging outward FDI

Foreign risk insurance Risks of expropriation (nationalization) War losses Inability to transfer profits back home

Capital assistance Special funds or banks to make government loans to encourage domestic

firms to undertake FDI

Tax incentives Eliminate double taxation of foreign income (host & home governments)

Political pressure Use political influence to encourage host countries to reduce FDI

restrictions

FDI & Government PolicyHome CountryRestricting Outward FDI

Limit capital outflows out of concern for the balance of payments

Manipulated tax rules to encourage their firms to invest at home – create jobs at home

Countries sometimes prohibit national firms from investing in certain countries for political reasons. (Cuba, South Africa)

FDI & Government PolicyHost CountryEncouraging inward FDI

Offer incentives for foreign firms to invest in their countries

Tax concessions Low-interest loans New state spending on infrastructure Grants or subsidies

Desire to gain from the resource transfer and employment effects

Desire to capture FDI away from other potential host countries

FDI & Government PolicyHost CountryRestricting inward FDI Ownership restraints

Foreign companies excluded from specific fields – national security or competition (infant industry)

Significant proportion of the equity of the subsidiary must be owned by local investors – maximize resource-transfer & employment benefits

Performance requirements Maximize the benefits and minimize the costs Related to local content, exports, technology

transfer & local participation by top management

International Institutions & FDI

WTO Embraces the promotion of trade in

services Many services need to be produced

where they are sold Push for the liberalization of FDI

particularly in services Less successful in establishing universal

rules with regards to FDI

Managerial Implications Relative profitability of FDI, exporting &

licensing vary with circumstances

As transport costs & trade barriers increase, FDI or licensing are better

Licensing not best when have valuable know-how or need tight control

Host governments attitude toward FDI important variable in where to locate production