FOREIGN DIRECT INVESTMENT

DEFINITION OF FDI Foreign Direct Investment : occurs when a firm invests directly in facilities to produce and / or market a foreign product. In other words , it’s the direct hands on-management of foreign assets Foreign Portfolio Investment: investment in a portfolio of foreign securities such as stocks and bonds that do not entail the active management of foreign assets If you own foreign stocks and bonds, you just have to collect dividends or interests , that’s all.

Horizontal FDI Vertical FDI Duplicates its home country based activities at the same value chain stage in a host country through FDI Example: Endesa generates and distributes electricity in Spain. Through horizontal FDI, it does the same type of activity in host countries in Latin America. Vertical FDI A type of FDI in which a firm moves upstream or downstream in different value chain stages in a host country

Example If VW only assembles cars and does not manufacture components in Germany, but in Spain, it enters into components manufacturing through FDI (an upstream activity), this would be upstream vertical FDI. Likewise, if VW does not engage in car distribution in Germany but invests in car dealerships in France or Italy , it would be downstream vertical FDI

Terms to know FDI flow is the amount of FDI moving in a given period (usually a year) in a certain direction. FDI inflow refers to inbound FDI moving into a country and FDI outflow refers to outbound FDI moving out of a country. FDI stock is the value of foreign owned firms operating in a country, or controlled by a country’s firms abroad.

MNE VERSUS NON-MNE An MNE , by definition is a firm that engages in FDI Non-MNE firms can also do business abroad through :exporting and importing, licensing and franchising, outsourcing , or through engaging in FPI For example, Zara would not be an MNE if it manufactured all its clothes in Spain and exported them around the world. Zara became an MNE only when it started to directly invest abroad, for instance in shops and distribution centers.

FDI IN BANGLADESH Inflows of foreign direct investment into Bangladesh rose 24 percent year-on-year to $1.6 billion in 2013 although the country witnessed serious political unrest and an anti-business climate during the period. Of the $1.6 billion FDI that Bangladesh received last year, $541 million came as equity (direct investment in Bangladesh), $361 million as intra-company loans (debt transactions between parent enterprises and affiliates) and $697 million were reinvested earnings (investors' share of profits not distributed as profits). By registering the growth, Bangladesh secured the second position among eight Saarc nations, outpacing Pakistan in attracting foreign investors. India continued to be the leader in luring foreign investors. Source : WIR report June 2014, UNCTAD, BOI

FDI MODES OF ENTRY (EQUITY MODES) The format of foreign market entry: GreenFields: building new factories and offices from scratch. A Greenfield operation allows investors to create a new operation from scratch according to their own designs and hence match it with their global organization. Acquisitions: Expansion of business by the take over of another business. Mergers: The combination of two companies to form a single new entity Joint Ventures: A new corporate entity given birth and jointly owned by two or more parent companies

Greenfield Versus Joint Venture Advantages of Green field Design operations fit the parent Complete equity and operational control, hence better protection of know how and ability to coordinate globally Disadvantages of Green Field Adds new capacity to industry which will make a competitive industry more crowded and thus increase the intensity of competition Suffer from a slow speed of entry ( in contrast to acquisitions). Takes a few years to build a new plant and establish new distribution channels Advantages of Joint Venture Sharing of costs , risks and profits Access to partners knowledge and assets (technological know-hows etc) Politically acceptable (entry into emerging economies) Disadvantages of Joint venture Limited equity and operational control Difficult to coordinate globally Divergent goals and interests of partners.

Greenfield Versus Mergers & Acquisitions Merger and acquisition are quicker to execute. Acquiring ready–made international network of subsidiaries owned by acquisitions. Existing assets of acquired: brand name, local knowledge, distribution network, customer relationships etc. (also reducing risk) Potential for efficiency gains by transferring capital, technology or management skills.

Why Foreign Direct Investment? Exporting: involves producing goods at home and then shipping them to overseas market for sale. Disadvantages of exporting: Transportation costs can be high which may reduce profit margin Tariff and non- tariff barriers FDI may be a response to threatened trade barriers

Why Foreign Direct Investments Licensing Involves granting a foreign entity the right to produce and sell the firms product in return for a royalty fee on every unit sold Disadvantages of licensing Dissemination risk, defined as the risk associated with unauthorized diffusion of firm-specific know-how Certain types of knowledge may be too difficult to transfer to licensees without FDI. Knowledge has two categories : Explicit knowledge is codifiable (driving manual) Tacit knowledge is non-codifiable ( memorizing the manual wont make you a good driver) Doesn’t give the firm tight control over manufacturing, marketing and strategy it may need in the foreign country to increase sales Licensing : involves granting a foreign entity the right to produce and sell the firm’s product in return for a royalty fee on every unit sold. Giving away valuable technological knowhow Does not give tight control over manufacturing, marketing and strategy Other capabilities to manufacture the products (e.g. management, marketing and manufacturing capabilities)

Why do firms become MNE by engaging in FDI? MNE engage in FDI due to some form of economic gains . John Dunning developed a framework known as OLI paradigm which proposes that FDI is the most appropriate form of international business if three conditions are met. Ownership, Location, Internalization advantages. (OLI)

Ownership Advantages The firm possesses ownership advantages, defines as resources of the firm that are transferable across borders, and that enable the firm to attain competitive advantages abroad. Firms are at a natural disadvantage when competing in a foreign country (liability of outsider-ship). O-advantages enable MNEs to overcome this liability when competing abroad.

Example Swedish Furniture retailer IKEA has found that its Scandinavian style of furniture combined with do-it-yourself flat packaging is very popular around the globe. IKEA thus has become a cult brand in many countries.

Location Advantages Operation at the certain location allows MNEs to create value it would not be able to create at home. L-advantages include in particular access to local markets and to resources, such as human capital and raw materials. Protectionism : in the form of tariffs or non-tariff barriers may inhibit exports. MNEs can “jump over” these protectionist barrier by setting up local production Transportation costs continue to be a major barrier to trade in some industries. Some products are still costly to transport over long distances if they are perishable goods , breakable, heavy or bulky.

Location Advantages Direct interaction with the customer: essential in industries where associated services such as just-in – time delivery or after sales services are an essential part of the product offering The production and sale of some services: cannot be physically separated, for example in hotels, banking or consultancy. The delivery of such services thus normally requires a local presence

Location bound resources are tied to a specific country, and form part of a country’s L- advantages. These include natural resources like raw materials, agricultural land, and geography as well as human capital and infrastructure. Oil majors like Shell and BP invest in oil exploration at many inhospitable places around the world

Location Advantages L – advantages also arise from the clustering of economic activities in certain locations – referred to as “agglomeration”. Agglomeration as L- advantages The advantages of locating in a cluster stem from (a) Knowledge spillovers among closely located firms that attempt to hire individuals from competitors, (b) industry demand that creates a skilled labor force whose members may work for different firms without having to move out of the region, ( c) industry demand that facilitates a pool of specialized suppliers and buyers to also locate in the region

Internalization Advantages The key advantage of FDI over other modes is the ability to replace “internalize” external market relationships with one firms (the MNE) owning, controlling, and managing activities in two or more countries . This is important because compared with domestic transaction costs, international transaction costs tend to be higher. For example: costs of monitoring performance are higher where language and other communication barriers arise

Internalization Advantages FDI affords a high degree of direct management control that reduces the risk of firm-specific resources and capabilities being opportunistically taken advantage of. FDI provides more direct and tighter control over foreign operations. Even when licensees (and their employees) have no opportunistic intension to take away “secrets”, they may not follow the wishes of the foreign firm that provides the know-how Look at the advantages of FDI over Licensing and Exports

Home country government policies towards FDI Encouraging Outward FDI For example, government backed insurance programs, special funds or loans to firms wishing to invest in developing countries, elimination of double taxation and home country’s political influence on host countries. Restricting Outward FDI for example, limiting capital outflows out of concern for country’s balance of payments, manipulation of tax laws and prohibiting national firms from investing in certain countries

Host country government policies towards FDI Encouraging Inward FDI for example, incentives like tax concessions, new state spending on infrastructure and low interest loans Restricting Inward FDI For example owner restraints and performance requirements Owner restraints: for example, foreign companies are excluded from specific fields, foreign ownership is permitted through a significant proportion of the equity has to be locally owned) Performance requirements for example, controls over the behavior of MNEs local subsidiary. The use of local content, exports, technology transfer and local participation in top management)

Host Country Benefits & Costs Resource Transfer Effects Employment Effects Balance of Payment Effects Effect on Competition and Economic Growth Costs Adverse Effects on Competition Adverse Effects on the Balance of Payments National Sovereignty and Autonomy

Home Country Benefits & Costs Inward flow of foreign earnings Employment effects arising from demand for home- country exports Learning valuable skills from its exposure to foreign markets Costs Initial capital outflow to finance the FDI Deficit balance of payments if the purpose of Foreign investment is to serve the home market from a low cost production location. Reduction in home country’s employment.