International Economics Tenth Edition CHAPTER T W E L V E 12 International Economics Tenth Edition International Resource Movements and Multinational Corporations Dominick Salvatore John Wiley & Sons, Inc. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

In this chapter: 1. Introduction 2. Some Data on International Capital Flows 3. Motives for International Capital Flows 4. Welfare Effects of International Capital Flows 5. Multinational Corporations Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

Two main types of foreign investments: 1. Introduction International trade and movement of productive resources are substitutes. As with trade, the movement of resources between nations tends to equalize factor returns. Two main types of foreign investments: Portfolio investments Direct investments Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

Portfolio Investments 1. Introduction Portfolio Investments Purely financial assets, such as bonds or less than 10% of voting stock, denominated in a national currency. Take place primarily through financial institutions such as banks and investment funds. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

1. Introduction Direct Investments Real investments in factories, capital goods, land and inventories where both capital and management are involved and the investor retains control over use of invested capital. Usually takes form of a firm starting a subsidiary or taking control of another firm. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

2. Some Data on International Capital Flows Table 12.1. US foreign Long-Term Private International Investment Position, 1950-2008 Table 12.2. U.S. Direct Investments Abroad by Area, 1950-2008 Table 12.3. U.S. Foreign Long-Term Private International Investment Position, 1950-2008. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

2. Some Data on International Capital Flows Figure 1. Trend of East Asia’s Net Portfolio Investment in the U.S. 2002-2012 (US$ million) Blue-China; Red- Japan; Green-EA developing countries Source: Calculated by HHLEE using US Treasury Department’s TIC Database

2. Some Data on International Capital Flows Figure 2. Trend of East Asia’s Net Equity Investment in the U.S. 2002-2012 (US$ million) Blue-China; Red- Japan; Green-EA developing countries Source: Calculated by HHLEE using US Treasury Department’s TIC Database

2. Some Data on International Capital Flows Figure 3. Trend of East Asia’s Net Long-term Security Investment in the U.S. 2002-2012 (US$ million) Blue-China; Red- Japan; Green-EA developing countries Source: Calculated by HHLEE using US Treasury Department’s TIC Database

3. Motives for International Capital Flows International Portfolio Investments The basic motive for international portfolio investment is to earn higher returns abroad. Portfolio theory tells us that by investing in securities with yields that are inversely related (like foreign and domestic securities) over time, a given yield can be obtained at a smaller risk, or a higher yield can be earned with the same level of risk for the portfolio as a whole. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

3. Motives for International Capital Flows International Portfolio Investments So a portfolio including both domestic and foreign securities can have a higher average yield and/or lower risk than one containing only domestic securities. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

3. Motives for International Capital Flows Direct Foreign Investments The basic motive for direct foreign investment is to earn higher returns (possibly from higher growth rates abroad, more favorable tax treatment or greater availability of infrastructure) and to diversify risks. Large corporations often have unique product knowledge or managerial skill that could easily and profitably be used abroad and over which the corporation wants to retain direct control. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

3. Motives for International Capital Flows Direct Foreign Investments Horizontal integration is the production abroad of a differentiated product that is also produced at home. Vertical integration (backward) allows a corporation to obtain control of a needed raw material and thus ensure uninterrupted supply at lowest possible cost, or acquire later stages in the production process, or ownership of sales or distribution networks abroad (forward). Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

Vertical integration: offshoring Figure 7.2 The Value Chain of a Product Any product has many different activities involved in its manufacture. Panel (a) lists some of these activities for a given product in the order in which they occur. The value chain in (b) lists these same activities in order of the amount of skilled/unskilled labor used in each. In panel (b), the assembly activity, on the left, uses the most unskilled labor, and R&D, on the right, uses the most skilled labor. Because we assume that the relative wage of skilled labor is higher at Home and that trade and capital costs are uniform across activities, there is a point on the value chain, shown by line A, below which all activities are outsourced to Foreign and above which all activities are performed at Home. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

3. Motives for International Capital Flows Direct Foreign Investments Also done to avoid tariffs and other restrictions that nations impose on imports, or to take advantage of government subsidies encouraging direct foreign investment. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

Greenfield FDI vs. M&A Greenfield FDI: M&A: Set up a new company “from the ground up” in the foreign country Examples: M&A: Buying shares of an enterprise in another country. 16 16

Figure 4. Trend of FDI outflows from all OECD countries, 2001-2011 Source: OECD International Direct Investment Statistics Database

Figure 5. Trend of M&A and Greenfied FDI outflows from 20 OECD countries, 2001-2011

Reasons for rapid increase in FDI Flow and stock increased in the last 30 years. FDI has grown more rapidly than world trade because: MNEs see the entire world as their market. Political and economic environment has changed in favour of FDI in many countries. FDI is seen as a way of circumventing trade barriers 19 19

4. Welfare Effects of International Capital Flows: Benefits of FDI Resource Transfer Stable source of foreign capital Advanced technology Advanced management skills Creation of employment opportunities True with greenfield FDI Not so true with M&E Stronger competition Domestic market becomes more efficient with stronger competition among firms Positive effects on Balance of Payment (BOP) Capital inflow with initial FDI When the goods/services produced by the FDI substitute for imported goods/services When the goods/services produced by the FDI are exported to another country Economic growth To some extent, FDI may help the economy grow faster 20 20

4. Welfare Effects of International Capital Flows: Costs of FDI Adverse effects on competition Foreign firms (MNEs) may have too much power and kill off competition Adverse effects on BOP After initial inflow of capital, subsequent outflow of capital from the earnings of the FDI Import inputs from abroad for the foreign firms Weakening of national sovereignty Possible loss of economic independence as some decisions that affect the host country’s economy may be made by a foreign company that has no real commitment to the host country 21 21

5. Multinational Corporations Multinational corporations (MNCs) own, control, or manage production and distribution facilities in several countries. Today, MNCs account for about 25% of world output, with intrafirm trade estimated at about one third of total world trade in manufacturing. Most international direct investments are undertaken by MNCs. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

5. Multinational Corporations Reasons for MNCs Integration may increase profits through better control of supply chains. The larger scale of production may allow the firm to better exploit economies of scale. MNCs can better direct production to low cost nations. MNCs can artificially change prices to only show profits in low tax nations (transfer pricing). Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

5. Multinational Corporations Problems in Home Country Loss of domestic jobs to other countries. MNCs may move technology out of the home country reducing the technological advantage of the home country. Transfer pricing may reduce taxable income and tax revenue. Access to foreign markets allows MNCs to circumvent domestic monetary and fiscal policy control. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

5. Multinational Corporations Problems in Host Country MNCs are alleged to dominate their economies. R&D funds are siphoned off to the MNC’s home nation, keeping host nation technologically dependent. MNCs may extract from host nations most of the benefits of their investment, either through tax and tariff benefits or tax avoidance. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

5. Product Fragmentation and Foreign Outsourcing What is international product fragmentation? The geographic separation of activities involved in producing a good (or service) across two or more countries’. Alternative terms: vertical specialization, slicing the value chain, international production sharing outsourcing, or trade in intermediate goods. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

5. Product Fragmentation and Foreign Outsourcing

5. Product Fragmentation and Foreign Outsourcing What is importance of international product fragmentation? Reinforces the linkage between trade and FDI policies. Makes a strong case for the removal/harmonisation of non- border policy barriers with a view to enhancing gains from global integration Has implications for the debate on regional versus multilateral (global) economic integration approaches to international trade policy.

Figure 4: World trade in parts and components (P&C) (Unit Billion US$) Source: Data calculated from UN Comtrade database

Figure 5: Share of parts and components trade of China compared with the world average Source: Data calculated from UN Comtrade database