Chapter-7 Foreign Direct Investment Theory & Strategy

Overview Present motives for initiating direct foreign investment Illustrate the benefits of international diversification Foreign Direct Investment prospects and Problems in Bangladesh

Definition of FDI FDI stands for Foreign Direct Investment, a component of country’s national financial accounts. It is an investment of foreign assets into domestic structures, equipment, business and organizations. Foreign Direct investment is defined as an investment, involving a long-term relationship and reflecting a lasting and control by a resident entity in one economy (foreign direct investor or parent enterprise), in an enterprise resident in one economy other than that of the foreign direct investor enterprise or affiliate enterprise or foreign affiliate. It is also defined as equity held by investors who hold managerial authority in business operations in other countries. FDI refers to investment made to acquire lasting interest in enterprises operating outside of the economy of the investor.

Components of FDI Equity capital: It is the FD investor’s purchase of shares of an enterprise in a country other than its own. Reinvestment Earnings: It comprise the direct investors’ share of earnings not distributed as dividends by affiliates, or earnings not remitted to the direct investor. Such retained profits by affiliates are reinvested. Intra-Company Loans: It refers to short or long-term borrowing and lending of funds between direct investors and affiliated enterprise.

Benefits of Direct Foreign Investment Attract new sources of demand Enter markets in which superior profits are possible Fully benefit from economies of scale Use foreign factors of production Use foreign raw materials Use foreign technology Exploit monopolistic advantages React to exchange rate movements React to trade restrictions Diversity internationally

Disadvantages of Direct Foreign Investment Dependent Upon The Market Expense Of Establishing Subsidiaries Uncertainty Of Inflation And Exchange Rate Movement Political Risk

FDI Theory & Strategy

Theory of Comparative Advantage The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless information, and no government interference.

Features of Theory of Comparative Advantage Exporters in Country A sell goods or services to unrelated importers in Country B Firms in Country A specialize in making products that can be produced relatively efficiently, given Country A’s endowment of factors of production, that is, land, labor, capital, and technology Firms in Country B do likewise, given the factors of production found in Country B In this way the total combined output of A and B is maximized

Features of Theory of Comparative Advantage…. Because the factors of production cannot be moved freely from Country A to Country B, the benefits of specialization are realized through international trade The way the benefits of the extra production are shared depends on the terms of trade, the ratio at which quantities of the physical goods are traded Each country’s share is determined by supply and demand in perfectly competitive markets in the two countries Neither Country A nor Country B is worse off than before trade, and typically both are better off, albeit perhaps unequally

Example of Comparative Advantage Assume the following….. Production unit is a mix of land, labor, capital and technology Examples continues to Exhibit 15.1, 15.2, 15.3 and 15.4 in the Text book Production capacity Containers of Sports Shoes Containers of Stereo Equipments Thailand has 1000 production units 12 ctrs/unit 6 ctrs/unit Brazil has 1000 production units 10 ctrs/unit 2 ctrs/unit

Limitations of Comparative Advantage Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for the following reasons: Countries do not appear to specialize only in those products that could be most efficiently produced by that country’s particular factors of production (as a result of government interference and ulterior motivations) At least two factors of production – capital and technology – now flow directly and easily between countries Modern factors of production are more numerous than in this simple model

Limitations of Comparative Advantage Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory Comparative advantage shifts over time, as less developed countries become developed and realize their latent opportunities The classical model of comparative advantage did not really address certain other issues, such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale

Limitations of Comparative Advantage…. Comparative advantage is however still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNCs and domestic firms. The comparative advantage of the 21st century, however, is one based more on services, and their cross-border facilitation by telecommunications and the Internet. The source of a nations comparative advantage is still created from the mixture of its own labor skills, access to capital, and technology.

Supply Chain Outsourcing Many locations for supply chain outsourcing exist today (see the following exhibit). It takes a relative advantage in costs, not just an absolute advantage, to create comparative advantage. Clearly, the extent of global outsourcing is reaching out to every corner of the globe.

Market Imperfections: A Rationale for the Existence of the Multinational Firm MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets. Imperfections in the market for products translate into market opportunities for MNEs. Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than are their local competitors.

Why do Firms Become Multinational? Strategic motives drive the decision to invest abroad and become a MNE and can be summarized under the following categories: Market seekers Raw material seekers Production efficiency seekers Knowledge seekers Political safety seekers These categories are not mutually exclusive.

Sustaining and Transferring Competitive Advantage by MNEs In deciding whether to invest abroad, management must first determine whether the firm has a sustainable competitive advantage that enables it to compete effectively in the home market. The competitive advantage must be firm-specific, transferable, and powerful enough to compensate the firm for the potential disadvantages of operating abroad (foreign exchange risks, political risks, and increased agency costs).

Competitive Advantages of MNCs Economies of Scale and Scope Managerial and Marketing Expertise Advanced Technology Financial Strength Differentiated products Competitiveness of Home market

supporting Industries Exhibit 15.7 Determinants of National Competitive Advantage: Porter’s Diamond (1) Factor conditions (4) Firm strategy, structure, & rivalry (2) Demand conditions (3) Related and supporting Industries Source: Michael Porter, “The Competitive Advantage of Nations,” Harvard Business Review, March-April 1990.

The OLI Paradigm and Internalization The OLI Paradigm is an attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through alternative models such as licensing, joint ventures, strategic alliances, management contracts, and exporting. “O” owner-specific (competitive advantage in the home market that can be transferred abroad) “L” location-specific (specific characteristics of the foreign market allow the firm to exploit its competitive advantage) “I” internalization (maintenance of its competitive position by attempting to control the entire value chain in its industry)

Where to Invest? The decision about where to invest abroad is influenced by behavioral factors. The decision about where to invest abroad for the first time is not the same as the decision about where to reinvest abroad. In theory, a firm should identify its competitive advantages, and then search worldwide for market imperfections and comparative advantage until it finds a country where it expects to enjoy a competitive advantage large enough to generate a risk-adjusted return above the firm’s hurdle rate. In practice, firms have been observed to follow a sequential search pattern as described in the behavioral theory of the firm.

Where to Invest?.... The decision to invest abroad is often a stage in the firm’s development process. Eventually the firm experiences a stimulus from the external environment, which leads it to consider production abroad. Some important external stimuli are: An outside proposal, from a quality source Fear of losing a market The “bandwagon” effect Strong competition from abroad in the home market

How to Invest Abroad: Modes of Foreign Involvement The globalization process includes a sequence of decisions regarding where production is to occur, who is to own or control intellectual property, and who is to own the actual production facilities. The following exhibit provides a roadmap to explain this FDI sequence.

Exhibit 15.9 The FDI Sequence: Foreign Presence & Foreign Investment The Firm and its Competitive Advantage Greater Foreign Presence Change Competitive Advantage Exploit Existing Competitive Advantage Abroad Greater Foreign Investment Production at Home: Exporting Production Abroad Licensing Management Contract Control Assets Abroad Joint Venture Wholly-Owned Affiliate Greenfield Investment Acquisition of a Foreign Enterprise

Modes of Foreign Involvement Exporting Vs production Aboard Licensing and Management Contracts Vs Control of Assets Abroad Joint venture Vs Wholly Owned Subsidiary Greenfield Investment Versus Acquisition Strategic Alliances

Exporting versus production abroad: There are several advantages to limiting a firm’s activities to exports as it has none of the unique risks facing FDI, Joint Ventures, strategic alliances and licensing with minimal political risks The amount of front-end investment is typically lower than other modes of foreign involvement Some disadvantages include the risks of losing markets to imitators and global competitors

Licensing and management contracts versus control of assets abroad: Licensing is a popular method for domestic firms to profit from foreign markets without the need to commit sizeable funds However, there are disadvantages which include: License fees are lower than FDI profits Possible loss of quality control Establishment of a potential competitor in third-country markets Risk that technology will be stolen

Licensing and management contracts versus control of assets abroad…. Management contracts are similar to licensing, insofar as they provide for some cash flow from a foreign source without significant foreign investment or exposure Management contracts probably lessen political risk because the repatriation of managers is easy

Joint venture versus wholly owned subsidiary A joint venture is here defined as shared ownership in a foreign business Some advantages of a MNE working with a local joint venture partner are: Better understanding of local customs, mores and institutions of government Providing for capable mid-level management Some countries do not allow 100% foreign ownership Local partners have their own contacts and reputation which aids in business

Joint venture versus wholly owned subsidiary However, joint ventures are not as common as 100%-owned foreign subsidiaries as a result of potential conflicts or difficulties including: Increased political risk if the wrong partner is chosen Divergent views about the need for cash dividends, or the best source of funds for growth (new financing versus internally generated funds) Transfer pricing issues Difficulties in the ability to rationalize production on a worldwide basis

Greenfield investment versus acquisition A Greenfield investment is defined as establishing a production or service facility starting from the ground up Compared to a Greenfield investment, a cross-border acquisition is clearly much quicker and can also be a cost effective way to obtain technology and/or brand names Cross-border acquisitions are however, not without pitfalls, as firms often pay too high a price or utilize expensive financing to complete a transaction

strategic alliance The term strategic alliance conveys different meanings to different observers. In one form of cross-border strategic alliance, two firms exchange a share of ownership with one another. A more comprehensive strategic alliance, partners exchange a share of ownership in addition to creating a separate joint venture to develop and manufacture a product or service Another level of cooperation might include joint marketing and servicing agreements in which each partner represents the other in certain markets.

FDI In Bangladesh

Desired Foreign Investment Categories Export oriented industries Industries in the Export processing Zones High technology products that will be either import substitute or export oriented Undertaking in which more diversified use of indigenous natural resources is possible Basic industries based mainly on local raw materials

Prohibited sector of FDI in Bangladesh Arms and ammunition and other defense equipment and machinery Forest plantation and mechanized extraction within the bounds of reserved forests Production of nuclear energy and Security printing and mining