Foreign Direct InvestmentForeign Direct Investment

Wayne Lippman

Foreign Direct InvestmentForeign Direct Investment

Why is FDI increasing in the world economy? Why do firms often prefer FDI to other market

entry strategies? Why do firms imitate competitors with FDI

strategies? Why are certain locations favored for FDI? How does political ideology affect government

FDI policy? What are key FDI related costs and benefits for

receiving and source countries?

Foreign Direct InvestmentForeign Direct Investment

Foreign direct investment (FDI): a firm invests directly in foreign facilities

A firm that engages in FDI becomes a multinational enterprise (MNE)– Multinational = “more than one country”

Factors which influence FDI are related to factors that stimulate trade

Foreign Direct InvestmentForeign Direct Investment

Involves ownership of entity abroad for– production– Marketing/service– R&D– Access of raw materials or other resource

Parent has direct managerial control– Depending on its extent of ownership and – On other contractual terms of the FDI

No managerial involvement = portfolio investment

FDI Growth in the World FDI Growth in the World EconomyEconomy

FDI Outflow: $35 billion in ‘75 to $1.3 trillion in ‘00 to $653 billion in ‘03

FDI Flow (from all countries): from ‘92 to ‘02 up 292%, compared to trade up 69% and world output up 28%

FDI Stock: $3.5 trillion by ‘97 to > $7 trillion in ‘02 In ‘02:

– 64,000 MNEs had: 850,000 foreign affiliates 53 million employees $17.7 trillion in sales

– $8 trillions global exports Conclusion:

FDI flow growing faster than world trade and world output

Direction and Source of FDIDirection and Source of FDI Most FDI flow has been to developed

countries from developed countries– Much to the US from EU, Japan

FDI increase to developing countries since ‘85– Much to the emerging Asian and Latin

America economies – Africa lagging

Forms of FDIForms of FDI

FDI forms– Purchase of assets: why? why not?

Quick entry, local market know-how, local financing may be possible, eliminate competitor, buying problems

– New investment: why? why not? No local entity is available for sale, local financial incentives, no

inherited problems, long lead time to generation of sales– International joint-venture

Shared ownership with local and/or other non-local partner Shared risk

Alternative Modes of Market EntryAlternative Modes of Market Entry

FDI– FDI - 100% ownership– FDI < 100% ownership, International Joint

Venture Strategic Alliances (non-equity) Franchising Licensing Exports: Direct vs Indirect

Why FDI?Why FDI?

FDI over exporting– High transportation costs, trade barriers

FDI over licensing or franchising– Need to retain strategic control– Need to protect technological know-how– Capabilities not suitable for licensing/franchising

Follow few main competitors– Immediate strategic responses

Pattern of FDI ExplanationsPattern of FDI Explanations

International product life-cycle (Ray Vernon)– Trade theory similarity

Eclectic paradigm of FDI (John Dunning)– Combines ownership specific, location specific,

and internalization specific advantages – Explains FDI decision over a decision to enter

through licensing or exports

Eclectic Paradigm of FDI (Dunning)Eclectic Paradigm of FDI (Dunning) Ownership advantage: creates a monopolistic advantage to be

used in markets abroad– Unique ownership advantage protected through ownership – e.g., Brand, technology, economies of scale, management know-how

Location advantage: the FDI destination market must offer factors (land, capital, know-how, cost/quality of labor, economies of scale) that are advantageous for the firm to locate its investment there (link to trade theory)

Internalization advantage: transaction costs of an arms-length relationship --licensing, exports-- higher than managing the activity within the MNC’s boundaries

Government Policy and FDIGovernment Policy and FDI The radical view: inbound FDI harmful; MNEs

– Are imperialist dominators– Exploit host to the advantage of home country– Extract profits from host country; give nothing back– Keep LDCs backward and dependent for investment,

technology and jobs The free market view: FDI should be encouraged

– Adam Smith, Ricardo, et al: international production should be distributed per national comparative advantage

– An MNE increases the world economy efficiency Brings to bear unique ownership advantages Adds to local economy’s comparative advantages

Host Country Effects of FDIHost Country Effects of FDIBenefits

– Resource -transfer– Employment– Balance-of-payment (BOP)

Import substitution Source of export increase

Costs– Adverse effects on the BOP

Capital inflow followed by capital outflow + profits Production input importation

– Threat to national sovereignty and autonomy Loss of economic independence

Government Policy and FDIGovernment Policy and FDIHome country

– Outward FDI encouragement Risk reduction policies (financing, insurance, tax incentives)

– Outward FDI restrictions National security, BOP

Host country– Inward FDI encouragement

Investment incentives Job creation incentives

– Inward FDI restrictions Ownership extent restrictions (national security; local nationals

can safeguard host country’s interests

Decision Framework for FDIDecision Framework for FDIExport

FDI

FDI

FDI

License

Yes

Import Barriers?No

No

Yes

No

Are transportation costs high?

Is know-how easy to license?

Tight control over foreign ops required?

Is know-how valuable and is protection possible?

No

Yes

Yes

No

Yes

About Wayne Lippman

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Wayne Lippman has forty years of experience in public accounting including twenty years with Price Waterhouse, where he served as a tax partner in the San Francisco and Oakland offices. He was previously Managing Tax Partner of the Walnut Creek office of Price Waterhouse.

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