Foreign Direct Investment This is a test

Foreign 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 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 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 Economy 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 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 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 Entry FDI FDI - 100% ownership FDI < 100% ownership, International Joint Venture Strategic Alliances (non-equity) Franchising Licensing Exports: Direct vs Indirect

Why FDI? FDI over exporting FDI over licensing or franchising 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 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) 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 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 FDI Benefits 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 FDI Home 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 FDI Import Barriers? 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 No No Export Yes No FDI Yes FDI Yes FDI No License

FDI: Benefits to the Host Country Resource Transfer Effects Capital MNE invests capital in foreign markets Technology Research supports that MNEs do transfer technology when they invest in a foreign country Management When MNEs invest and manage in a foreign country, they often transfer management skills to the host country’s workforce Employment Effects MNEs, by investing in foreign countries, can create employment opportunities for the local workforce But: Acquisition vs. Greenfield Investment Balance of Payment Effects Balance of Payment: A country’s balance-of-payment is the difference between the payments to and receipts from other countries FDI can have beneficial and negative effects on a country’s balance of payment. We look at the beneficial effects next Effect on Competition Efficient functioning of markets require adequate level of competition between producers

FDI: Benefits to Host Country’s Balance of Payment Initial Capital Inflow When a company invests in a foreign country, it brings capital into that country Substitute for Imports To the extent that the goods/services produced by the FDI substitute for imported goods/services, there is a positive effect on B-of-P Inflow of payments from export of goods and services To the extent that the goods/services produced by the FDI are exported to another country, there is a positive effect on the host country’s B-of-P

FDI: Costs to Host Countries Adverse Effects on Competition MNEs may have “too much” power and kill off competition Adverse Effects on Balance of Payments After initial inflow of capital, subsequent outflow of capital from the earnings of the FDI FDI may import inputs from abroad National Sovereignty and Autonomy Key decisions that affect the host country’s economy may be made by a foreign parent that has no real commitment to the host country

FDI: Benefits & Costs to Home Country Stream of income from foreign earnings FDI may import intermediate goods or inputs for production from the home country, creating jobs MNEs may learn skills from exposure to foreign countries Costs Balance of payment: Initial capital outflow (but often set off by future stream of foreign earnings) Current account suffers if FDI is to serve home market from low-cost production location Current account suffers if FDI is a substitute for direct export Employment effects: FDI a substitute for domestic production (e.g., Etch-A-Sketch)

Government Policy Instruments and FDI: Host Country Policies Encouraging Inward FDI Tax concessions Low-interest loans Grants Subsidies Restricting Inward FDI Ownership restraints Exclusion from certain industries Why do so? To protect national interest (defense, etc) To facilitate resource-transfer Performance requirements Local content, exports, technology transfer, and local participation in top management

Government Policy Instruments and FDI: Home Country Policies Encouraging Outward FDI Insurance programs to cover major types of foreign investment risks Special funds or banks to make government loans Political influence to persuade host countries to relax restrictions on inbound FDI Restricting Outward FDI Limit capital outflows Manipulate tax rules to encourage investment at home Outright prohibition from investing in certain countries

FDI: Definition What is FDI? Alternatives to FDI FDI occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country Examples: Motorola sets up a plant in China to manufacture cell phones Starbuck purchases an existing UK firm, “British Coffee,” to sell coffee, tea and desserts in the UK Volkswagen and two Chinese joint venture partners Shanghai Automotive Industry Corporation (SAIC) and First Automotive Works (FAW) open their newly built gearbox plant in Shanghai "Volkswagen Transmission (Shanghai) Co. Ltd" Alternatives to FDI Licensing; Direct Export

FDI: Forms Forms of FDI Acquisitions Greenfield Investments Examples: Purchase an existing company in the foreign country Greenfield Investments Set up a new company “from the ground up” in the foreign country Examples: Motorola investments money in China and builds a new plant to produce cell phones Starbucks purchases an existing UK firm “British Coffee” and sells coffee/tea/desserts under the name “Starbucks”

FDI: Forms (II) Forms of FDI (II) Wholly Owned Subsidiary Occurs when the company in the foreign country is entirely controlled/owned by one single company. Motorola’s company that manufactures cell phones in China Starbuck’s acquisition that sells coffee/tea/desserts in the UK Joint Ventures Occurs when two or more companies together form a new company in the host country In the international context, usually occurs when one (or more) foreign company and one (or more) local company join to form a new company Volkswagon + Shanghai Automotive Industry Corporation (SAIC) + First Automotive Works (FAW)

FDI: Horizontal vs. Vertical Horizontal vs. Vertical Direct Investment Horizontal Investment in the “same” industry as a firm operates in at home Examples: Starbucks and its international expansion MacDonald’s and its international expansion Vertical Investment in a downstream supplier (backward) or upstream purchaser (forward) as compared to the business that the firm operates in its home country Backward: Volkswagon + SAIC + FAW to produce gearbox (an input to Volkswagon’s home operation) Forward: Less common. Volkswagon’s acquisitions of dealers in the US (Volkswagon “sold” cars to the dealers in the US. I.e., Volkswagon sold the output of its home country operations to the US dealers that it acquired)

Why Horizontal FDI? Transportation Costs Market Imperfections Impediments to exporting Impediments to Sale of Know-How Strategic Behavior Product Life Cycle Location Specific Advantages

Why Vertical FDI? Strategic Behavior Market Imperfections Impediments to Know-How Investment in Specialized Assets