Foreign Direct Investment This is a test GEETA SHIROMANI ASSOCIATE PROFESSOR

Foreign Direct Investment Why is FDI increasing in the world economy? Why do firms often prefer FDI to other market entry 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 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 - Flow versus stock FDI occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country Flow: Amount of FDI over a period of time (one year) Stock: Total accumulated value of foreign owned assets at a given point of time FDI is not the investment by individuals, firms or public bodies in foreign financial instruments

Why is FDI important ? Firms want a presence in foreign markets Firms want control over growth of these foreign markets To gain first mover advantages To ward off competitors To determine locations, advertising and other related strategic decisions in the firm’s interest

Trends in FDI Flow and stock increased in the last 30 years In spite of decline of trade barriers, FDI has grown more rapidly than world trade because: Businesses fear protectionist pressures FDI is seen as a way of circumventing trade barriers Dramatic political and economic changes in many parts of the world Globalization of the world economy has raised the vision of firms who now see the entire world as their market

FDI Growth in the World Economy FDI Outflow: $35 billion in ‘75 to $1.3 trillion in ‘00 to $620 billion in ‘04 FDI Flow (from all countries): from ‘92 to ‘04 up 260%, compared to trade up 100% and world output up 32% FDI Stock: $3.5 trillion by ‘97 to more than $ 8.1 trillion in ‘03 In ‘03: 61,000 MNEs had: 9,00,000 foreign affiliates 54 million employees $17.6 trillion in global sales $9.2 trillions global exports Conclusion: FDI flow growing faster than world trade and world output

FDI- inflows & outflows

Direction 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

Inflows in developed vs. developing countries

Outflows in developed vs. developing countries

FDI trends: 2001-2002 The value of FDI slumped almost 60 percent in 2001-2002 Slowdown in world economy Heightened geopolitical uncertainty since September 11, 2001 Bursting of the stock market bubble in the US

Developed countries- FDI outflows

Top 10 sources of FDI outflows, 2005-06

Types of FDI FDI By Motive By Direction By Entry Mode By Target

Types of FDI By Direction Inward FDI Outward FDI

Types of FDI By Target Horizontal FDI Vertical FDI

Types of FDI Horizontal FDI: Vertical FDI: Investment in the same industry abroad as a firm operates in at home Vertical FDI: Backward Vertical FDI: investment in an industry abroad that provides inputs for the firm’s domestic production processes eg: oil refining, Royal Dutch/shell, British petroleum etc.) Forward Vertical FDI: investment in which an industry abroad sells the outputs of the firm’s domestic production processes eg: Volkswagon in U.S.

Strategic Asset Seeking Types of FDI By Motive Market Seeking Resource Seeking Strategic Asset Seeking Efficiency Seeking

Types of FDI: By Motive Resources seeking - looking for resources at a lower real cost. Market seeking - secure market share and sales growth in target foreign market. Efficiency seeking - seeks to establish efficient structure through useful factors, cultures, policies, or markets. Strategic asset seeking - seeks to acquire assets in foreign firms that promote corporate long term objectives.

Mergers & Acquisitions Types of FDI By Entry Modes Green-Field Ventures Mergers & Acquisitions

Green-field Ventures A Greenfield Investment is the investment in a manufacturing, office, or other physical company-related structure or group of structures in an area where no previous facilities exist. The name comes from the idea of building a facility literally on a "green" field, such as farmland or a forest. Green field operation: Mostly in developing nations

Mergers & Acquisitions Mergers and acquisitions: Quicker to execute. Foreign firms have valuable strategic assets Believe they can increase the efficiency of the acquired firm More prevalent in developed nations

FDI when and why? Transportation costs are high Market Imperfections (Internalization Theory) Impediments to the free flow of products between nations Impediments to the sale of know-how Follow the lead of a competitor - strategic rivalry Product Life Cycle - however, does not explain when it is profitable to invest abroad Location specific advantages (natural resources)

Pattern of FDI Explanations 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

Pattern of FDI Explanations 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

Pattern of FDI Explanations Eclectic Paradigm of FDI (Dunning) 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)

Pattern of FDI Explanations Eclectic Paradigm of FDI (Dunning) Internalization advantage: transaction costs of an arms-length relationship --licensing, exports-- higher than managing the activity within the MNC’s boundaries

Why FDI? High transportation costs, trade barriers 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

Decision framework Low High FDI Yes No Export How high are transportation costs and tariffs? Is know-how amenable to licensing? Is tight control over foreign operation required? Can know-how be protected by licensing contract? Then license Export No Yes Low FDI High

Factors affecting investment decisions Costs Barriers Control Incentives like tax concessions, subsidies etc Location advantages Essential Criteria Access to skilled and educated workforce Proximity to world class research institutions Quality of life Access to venture capital

Factors affecting investment decisions Important Criteria Reasonable costs of doing business Established technology presence Available bandwidth and adequate infrastructure Favorable business climate and regulatory environment Desirable Criteria Presence of suppliers and partners Availability of community incentives

Political Ideology and FDI Radical View Pragmatic Nationalism Free Market

The Radical View Marxist view: MNE’s exploit less-developed host countries Extract profits Give nothing of value in exchange Instrument of domination, not development Keep less-developed countries relatively backward and dependent on capitalist nations for investment, jobs, and technology

The Radical View By the end of the 1980s radical view was in retreat Collapse of communism Bad economic performance of countries that embraced the radical view Strong economic performance of some countries that embraced capitalism rather than the radical view

The Free Market View Adam Smith, Ricardo: international production should be distributed per national comparative advantage Nations specialize in goods and services that they can produce most efficiently Resource transfers benefit and strengthen the host country Pro-investment changes in laws and growth of bilateral agreements attest to strength of free market view But all countries impose some restrictions on FDI

Pragmatic Nationalism FDI has benefits and costs Allow FDI if benefits outweigh costs Block FDI that harms indigenous industry Encourage FDI that is in national interest Tax breaks Subsidies But who can predict which FDI is in national interest? Regulations open opportunity for favoritism

Pragmatic Nationalism Many of the most successful developing countries – past and present – followed a pragmatic nationalistic stance Japan South Korea China Economists note that Hong Kong, which followed the free market approach, was even more successful

The Benefits of FDI to Host countries Resource transfer effects Capital Technology Management Employment effects Effect on competition & economic growth

The Benefits of FDI to Host countries Balance of payment effects Initial capital inflows Import substitution Export of goods & services to other countries In a free market view Many economists argue that the benefits of FDI so outweigh the costs associated with pragmatic nationalism that it is misguided The best policy would be for countries to forgo all intervention in an MNE’s investment decisions

Costs of FDI to the Host Country Adverse effects on competition Adverse effects on balance of payment Outflow of earnings from foreign subsidiary to its parent company Imports of raw material results into adverse effect on current account Adverse effect on national sovereignty and Autonomy

Benefits of FDI to Home country Positive effect on Balance of payment due to inward flow of foreign earnings & demand of home-country exports of capital-equipments Employment effects due to demand of home country products MNE’s learn valuable skills from foreign markets that can be transferred back to the home country

Costs of FDI to Home countries Adverse effect on BOP account: Adverse effect on capital account due to outflow of capital Adverse effect on current account due to imports from low production locations in foreign countries Adverse effect on current account due to export substitution Reduced home country employment

Government Policy and FDI Home country Outward FDI encouragement Risk reduction policies (financing, insurance, tax incentives) Outward FDI restrictions National security, BOP

Government Policy and FDI 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

International institutions & the liberalization of FDI WTO (world trade organization) OECD (Organization for economic cooperation & development)