International Finance

Chapter 15

Foreign Direct Investment

Preliminary Concepts

• Trade and investment are the two fundamental ways in which global firms engage in overseas markets.

• Investment can take one of two forms:– Portfolio: Relatively short term; investors passive with

regard to control of invested assets.– Direct: relatively long term; involves an equity position

large enough to confer some degree of control.• Percentage for classifying DFI varies from country to country• U.S., Japan, and the OECD use 10%

Foreign Direct Investment (FDI)

• FDI Defined”

– FDI is the movement or accumulation of long term capital across political boundaries.

• It may take the form of:– Cash, securities, plant, equipment, and other factors

of production, such as managerial skills, technology, or know how.

– FDI usually involves some combination of the above.– The transfer of this “package” of capital assets as well

as the retention of control is what distinguishes FDI from portfolio investment.

Measuring FDI

• More broadly defined, FDI includes not only the movement, but also the accumulation of long term capital abroad.– For example, the United States includes

retained earnings and locally financed direct investments by American affiliates in its measure of FDI.

– Other countries, however, such as Japan, recognize only the movement of long term capital abroad as FDI.

Observations on FDI

• From 1997-2001, global FDI averaged about $830 billion annually.

• Developed countries account for about 85% of this amount.

• United States is the largest source and largest target, followed by the United Kingdom.– Large market, little political risk, developed business

environment.• Japan a relatively small target

– Reflects legal, economic and cultural barriers.• Growing importance of China as a target!

– Fourth most important target country.• FDI has grown faster than world exports!

Average Annual FDI (in Billions $) 1997-2001

(Outflows: Blue; Inflows: Red)5.5 29.4

1.7

91

65.8

12.6 28.5

1.7

46.6

31.1

21 25.3

134.5

139.2

7.4 29.3 43.5

38.8 62.2

8.3

6.7 15 37.1

18.6

25.5

9.3

71.7

202.3

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Italy

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FDI Compared to World Exports

0

100

200

300

400

500

600

90 92 94 96 9820

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Value ExportsWorld GDPWorld FDI

Note: The dramatic growth in FDI since 1997

Inde

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FDI Theories

• Theory: The purpose of theory is to “explain” or “predict” the behavior of a particular phenomena.– For example, why do firms engage in FDI?

• The theoretical development of FDI did not begin until 1960.– Prior to this, economists and, thus, theoretical modeling was

concerned with explaining international trade and portfolio investment.

• To this day FDI theories are still not as well developed as other theories of international economics (especially trade theories and portfolio diversification theories).

FDI Theory: 1960s

• Stephen Hymer (1960, Ph.D. thesis, MIT).– Monopolistic Advantage Theory of FDI

• Hymer, borrowing from market structure theory, suggested that monopolistic advantages (which allowed firms to generate above average profits) provided firms with the incentive to expand abroad.– Monopolistic advantages resulted in barriers to

competition and resulted from:• Brand loyalty, patents, managerial skills, etc.

FDI Theories: 1960s

• Raymond Vernon (1966, Quarterly Journal of Economics):– International Product Life Cycle of FDI

• Vernon’s theory attempts to explain the “timing and location” of FDI– Initially firms will undertake production in their home markets

(control and risk avoidance); generally highest income countries.– During the next stage, the firm will begin to export, but to

markets most similar to the home market (in demand patterns).– As the product matures and becomes standardized, the

competitive advantage shifts from product advantage to cost advantage.

– Initial producer is forced to seek lower cost production to remain competitive, and eventually establishes a manufacturing facility overseas (overseas production replaces exports and is also used to service the home market).

International Product Life Cycle Model

11 2 3 4 5 6 7 8 9 10 11 12 13 14 15

1 3 4 5 6 7 8 9 10 11 12 13 14 15

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Highest Income Countries

High Income Countries

Low Cost Location Countries

Time

Stages of Production DevelopmentNew Product Standardized ProductMaturing Product

Quantity

production

consumption

2

Exporting

Importing

Importing

FDI:Exporting

Importing

Eclectic Explanation of FDI

• Rather than focusing on any one theory, the eclectic approach attempts to identify possible motivating factors in affecting a firm’s decision to engage in FDI.

• Many of these factors tend to focus on various market imperfection and include:– Trade barriers– Imperfect labor markets– Intangible assets (internalization theory of FDI)– Vertical integration

Trade Barriers

• Trade barriers are those factors which discourage the movement of goods and services across national borders.– Impact on exports and imports

• Trade barriers arise from:– Government policies

• Tariffs, quotas, anti-dumping actions.

– Natural forces (e.g., transportation costs)

Trade Barriers and FDI

• FDI is seen as a strategy for circumventing trade barriers.– Japanese TV manufacturers moving production

facilities to the U.S. in 1977 in response to U.S. import quotas on Japanese tvs.

– Japanese automobile manufacturers establishing production facilities in the U.S. in the 1980s in response to the 1981 voluntary restraint agreement between the U.S. and Japan.

• Honda’s 1982 FDI investment in Marysville, Ohio– Haier Corporation (China) establishing a $40 million

refrigerator manufacturing facility in South Carolina in 2000 to overcome transportation costs.

Imperfect Labor Markets

• Firms may locate overseas production facilities on the basis of under-priced labor costs (relative to its productivity).– Why might labor be under-priced?

– Because labor cannot move freely across national borders to take advantage of higher wages elsewhere.

• Explains FDI investment in:

– China, Mexico, India, etc.

Labor Market Costs Around the World (2001)

Country Hourly Cost Germany $23.04 U.S. $20.67 Japan $19.52 Korea $7.53 Taiwan $5.44 Mexico China Indonesia

$1.70 $0.60 $0.22

Persistent wage differentials across countries exist. This is one on the main reasons MNCs are making substantial FDIs in less developed nations.

Intangible Assets

• Firms may engage in FDI if they possess intangible assets.– Technology, managerial talent, brand loyalty.– Firms owning these intangible assets find it

more beneficial to establish their own foreign subsidiaries then to license their intangible assets to a foreign partner.

• Assets may be difficult to transfer to partners.• Firm may wish to “protect” its assets; and not

share (Coca-Cola). Thus, Coke invests in bottling plants overseas!

Internalization Theory of FDI

• Suggests that those firms possessing intangible assets will use their own subsidiaries, rather than “local” host country firms to capture returns.– Avoids misappropriation of assets.– Avoids sharing technology.– Insures full control.

• Firms “internalize” their activities!

Vertical Integration

• Firms may engage in integrating FDI to stabilize a critical supply (of inputs) chain.– A gasoline company owning oil fields.– Referred to as backward integration!

• Firms may engage in integrating FDI to promote product sales.– Automobile manufacturing companies buying car

dealerships.• American car companies buying dealerships in Japan!

– Referred to as forward integration!

Viewing the FDI SequenceDomestic Firm Analyzes its

Competitive Advantage

Exploit Existing CompetitiveAdvantage Overseas

None: How to Develop itsCompetitive Advantage?

Licensing Firm’sCompetitive Advantage

Firm Controlled AssetsAbroad (FDI)

Acquisition of aForeign Enterprise

GreenfieldInvestment

Produce at Home:Exporting Produce Overseas

Joint Venture with Foreign Partners

Wholly-OwnedSubsidiary

Greater Foreign Presence

GreaterForeignInvestment

Joint Ventures

• Definition: A combination of two or more entities (companies, state enterprises) into a single business organization. – Each party contributes to the organization

(money, technology, plant, labor)

– Each party owns a portion of the organization (equal stakes or majority/minority stakes)

• Most are 50/50

– Each party shares risk of failure.

Reasons for Joint Ventures

• Possible Reasons for Joint Venturing:– Host government require it

• China, India and Malaysia

– Partners realize needs for each others’ skills• Managerial, production, distribution, understanding of the

country• Especially important when national cultures differ.

– Partners realize needs for each others’ complementary assets

• Technology, products, capital, plant, labor

– Large capital outlay requirements may render wholly owned subsidiary unfeasible.

Joint Venture Example: Nike Japan

• Nike Corporation: Headquartered in Oregon; designer and marketer of athletic footwear.– Founded in 1962 (as Blue Ribbon Sports)– 1963 Imported 200 pairs of athletic shoes

from Onitsuka Tiger Company in Japan (Importer stage)

– 1981: Nike Japan is created through a joint venture between Nike and Japanese trading company, Nissho Iwai (DFI stage)

Advantages of Joint Ventures

• Advantages include:– Combining with another firm and building on

both firm’s comparative advantages.– Limits capital outlay.

– Permits potentially better relations with local government, banks, labor unions, community!

– Minimizes cultural risk.

– Minimizes expropriation risk.

Disadvantages of Joint Ventures

• Disadvantages include:– Corporate disagreements

• Corporate culture clashes (Anglo-American versus non-Anglo-American views regarding corporate objectives)

– Sharing of profits– Usually one partner will dominate the

enterprise.

Wholly Owned Subsidiary

• Definition: A firm (parent company) with 100% ownership of an overseas enterprise.

• Features:– Firm does not share the organization with another

firm.• Firm contributes all the assets.

• Firm does not share profits.

• No control issues (no sharing of decision making).

– However, there is:• High cost

• Full risk exposure

Greenfield Versus Acquisition

• Greenfield Investment

– A greenfield investment is the construction of a new facility; “starting from the ground up.”• Usually requires extended periods of

physical construction and organizational development.

– Honda building an automobile assemble plant in Marysville Ohio in 1982!

Greenfield Versus Acquisition

• A cross-border acquisition refers to the purchase of an existing enterprise.– Shorter time frame and less financing

exposure.– Issues:

• Do appropriate foreign assets exist?• How much to pay for existing assets?

– Generally too much!– Potential problems with post acquisition

integration of firms

– Ford buying Jaguar for $2.8 billion in 1990!

Top 10 Cross-Border M&A Deals: 1996-01

U.S.ARCOU.K.BP Amoco PLC27.22000

U.K.Orange PLCGermanyMannesmann AG32.61999

U.S.Chrysler Corp.GermanyDaimer-Benz AG40.51998

GermanyDeutsche Telekom AG

U.S.VoiceStream Wireless Corp

29.42001

SwedenAstra ABU.K.Zeneca Group PLC34.61999

CanadaSeagram Co. LTDFranceVivendi SA40.42000

U.K.Orange PLCFranceFrance Telecom SA462000

U.S.AmocoU.K.British Petroleum Co.48.21998

U.S.Airtouch U.K.Vodafone Group PLC60.31999

GermanyMannesmann AGU.K.Vodafone Airtouch PLC

202.82000

HostTargetHomeAcquirer($ b)Year

Political Risk

• Relates to the actions that a host government might take that could adversely affect the interests of a global firm.

• Range from changes in tax laws to ownership issues.

• One of the biggest risk when investing abroad.

• Individual country’s legal system and the enforcement of its laws (relating to business) is also critical here!– Contract law, private property laws, intellectually property!

Political Risk Components

• Transfer Risk– Uncertainty regarding cross-border flows of capital (repatriation

of profits).• Imposition of capital controls, changes in withholding taxes on

dividends.

• Operational Risk– Uncertainty regarding host countries policies on firm’s operations.

• Changes in environmental regulations, local content requirements, minimum wage laws.

• Control Risk– Uncertainty regarding control or ownership of assets

(expropriation).• Changes in restrictions on maximum ownership by non-resident

firms, nationalization of foreign assets.

Assessing Political Risk

• Corruption Indexes– http://www.transparency.org/ (no fee)

• Country Analysis – http://www.state.gov/countries/– http://library.uncc.edu/display/?dept=reference&format=open&page=68

• Political Risk Indexes– http://www.duke.edu/~charvey/index.html (no fee)– http://www.countrydata.com/ (fee based)

• Insurance (OPIC)– http://www.opic.gov/

Case Study: Coca-Cola and Political Risk

• From the 1950s into the early 1970s, Coca-Cola had operated successfully in India as the country’s leading soft drink company.

• However, by the mid-1970s, the political environment in India towards non-resident firms changed dramatically.

Coca-Cola in India

• From 1974 to 1977, India’s socialist government had engaged in a four-year campaign against multinational firms in general and Coca-Cola in particular.

• In the case of Coca-Cola, the Indian government claimed that the company was taking more money out of the country then putting in and was adversely affecting its domestic soft-drink industry.

Coca-Cola and India

• In 1977 the government demanded that Coca-Cola turn over its secret drink formula and sell 60% of its operations to Indian investors or face expulsion.

• A year later, in 1978, Coca-Cola left India.

• Coca-Cola has since returned to India!