Six C h a p t e rC h a p t e r Foreign Direct Investment Part Three Cross-Border Trade and Investment

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. Foreign Direct Investment Foreign direct investment (FDI) happens when a firm invests directly in facilities in a foreign country 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 across national borders Slide 6-1

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. Foreign Direct Investment Involves ownership of entity abroad for  Production  Marketing/service  R&D  Raw materials or other resource access Parent has direct managerial control  The degree of direct managerial control depends on the extent of ownership of the foreign entity and on other contractual terms of the FDI  No managerial involvement = portfolio investment Slide 6-2

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. FDI Growth in the World Economy FDI Outflow of $35 billion in 1975 increased to $644 billion in 1998 FDI Flow from all countries increased 1000%, trade 91%, world output 27% from 1984 to 1998 FDI Stock increased to $3.5 trillion by ,000 parent MNEs with 500,000 foreign affiliates produced $11 trillion sales, 25% of global output FDI growing faster than world trade  Political risk issues  Economic reason issues  Globalization Slide 6-3

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. Direction and Source of FDI Historically, FDI flow was to developed countries from other developed countries  Much of this to the US Since 1985 there has been an increase of FDI towards developing countries  Much to the emerging Asian and Latin America economies  Africa lagging Through 1970s US led in FDI outflows  Japan 1st, UK 2nd, US 3rd  Effect of ¥ increase in value Slide 6-4

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. Forms of FDI FDI forms  Purchase of existing assets Quick entry, local market know-how, local financing may be possible, eliminate competitor, buying problems  New investment No local entity exists or is available for sale, local financial incentives may encourage, no inherited problems, long lead time to generation of sales or other desired outcome  Participation in an international joint-venture Shared ownership with local and/or other non-local partner Slide 6-5

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. Alternative Modes of Market Entry FDI  FDI - 100% ownership  FDI < 100% ownership, International Joint Venture Majority, Equal Share, Minority Participation Strategic Alliances (non-equity) Franchising Licensing Exports  Direct vs Indirect Slide 6-6

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. Why FDI? FDI over exporting  High transportation costs, trade barriers FDI over licensing or franchising  Need to retain strategic control  Need to protect technological knowhow  Capabilities not suitable for licensing/franchising Slide 6-7

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. Pattern of FDI Follow main competitors  Oligopolistic industries  Interdependence of the few major competitors forces immediate strategic responses International product life-cycle (Ray Vernon)  As explained in Chapter 4 Eclectic paradigm of FDI (John Dunning)  Combines ownership specific, location specific, and internalization specific advantages that drive FDI decisions over a decision to enter through licensing or exports Slide 6-8

Eclectic Paradigm of FDI (Dunning) Ownership advantage: creates a monopolistic advantage which can be used to prevail in markets abroad  Unique ownership advantage protected through ownership  e.g., Brand, technology, economies of scale, management know-how Location advantage: the FDI destination local market must offer factors (land, capital, know-how, cost/quality of labor, economies of scale) such that it is 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 MNE’s boundaries Source: Dunning, John H. (1980). “Towards an eclectic theory of international production: Some empirical tests.” Journal of International Business Studies 11(2): 9-31 Slide 6-9

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. Government Policy and FDI The radical view: inbound FDI harmful; MNEs  Are an instrument of imperialist domination  Exploit host to the advantage of home country  Extract profits from host country; give nothing back  Keep LDCs backward/dependent for investment, technology and jobs The free market view: FDI should be encouraged  Adam Smith, Ricardo, et al: international production should be distributed according to comparative advantage  The MNE increases the world economy efficiency because it brings to bear unique ownership advantages on the local economy’s comparative advantages Slide 6-10

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. 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 Slide 6-11

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. Home Country Effects of FDI Benefits  BOP current account adversely affected by inward flow of foreign earnings  Positive employment effect from increased exports of raw materials / assemblies to the overseas subsidiary  Repatriation of skills and knowhow Costs  BOP trade position is negatively affected (lower finished goods exports)  Loss of employment to overseas market Slide 6-12

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. 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 Slide 6-13

Irwin/McGraw-Hill Copyright  2001 The McGraw-Hill Companies, Inc. All rights reserved. Decision Framework for FDI Is know-how easy to license? Tight control over foreign ops required? Is know-how valuable and is protection possible? FDI License No Yes No Yes No Are transportation costs high? Export Import Barriers? Yes Slide 6-14