CH 7 Foreign Direct Investment Importance of FDI in world economy Theories used to explain FDI Government policy towards FDI

FDI Terms FDI = firm invests directly in facilities to produce and/or market a product in a foreign country Green-field investment = establishment of a new operation Acquiring or merging with an existing firm Multinational Enterprise = firm that owns business operations in more than one country

FDI Terms Flow of FDI = amount of foreign direct investment undertake over given period FDI outflows = FDI flow out of a country FDI inflows = FDI flow into a country Stock of FDI = total accumulated value of foreign owned assets at a given time

Growth of FDI Firms fear protectionist pressures Way of circumventing future trade barriers Political and economic changes – shift toward democratic political institutions and free market economies Globalization of the world economy

Drivers of FDI To get access to national markets Establish low cost manufacturing locations from which to serve regional or global markets Important to have production facilities based close to their major customers

Direction of FDI Historically directed at the developed nations US was largest recipient because Large and wealthy domestic market Stable economy Favorable political environment Openness to FDI

Direction of FDI Recent inflow targeted into developing nations – emerging economies Asia, especially China Latin America Inability of Africa to attract FDI Political unrest, armed conflict Frequent changes in economic policy

Source of FDI 60% of all FDI outflows US has been the largest source country UK, Netherlands, France, Germany, Japan 2002 – 100 largest multinationals 26% US 17% Japanese 12% French 12% German 10% British

Form of FDI Majority of cross-border investments in the form of mergers & acquisitions rather than green-field Developed nations 2/3 M&A Developing nations 1/3 M&A Why M&A Quicker and easier to execute than Green-field Acquire valuable strategic assets – brand loyalty, customer relations, trademarks & patents, distribution systems, production systems, etc. Increase efficiency of acquired unit by transferring capital, technology or management skills

Theories of FDI Why FDI when could export or license Why firms in same industry undertake FDI at same time & why certain locations are favored as targets Eclectic paradigm – combine the two

Alternative to FDI Exporting Producing good at home and shipping to receiving country for sale Limitations- viability is often constrained by transportation costs – unprofitable to ship some products over large distances trade barriers – import tariffs or quotas

Alternative to FDI Licensing Granting a foreign licensee the right to produce & sell the firm’s products in return for a royalty fee on every unit Limitations – Internalization theory Give away valuable technological know-how to potential foreign competitor Lack of control over manufacturing, marketing & strategy required to maximize profitability Firm’s competitive advantage may be based not on product, but on marketing, management or manufacturing process capabilities

FDI best entry strategy when Firm has valuable know-how that cannot be adequately protected by a licensing contract Firm needs tight control over a foreign entity to maximize its market share and earnings in that country Firm’s skills and know-how are not amenable to licensing

Pattern of FDI Knickerbocker - Mulitpoint competition Firms in the same industry often undertake FDI at same time Clear tendency to direct FDI toward certain locations Reflection of strategic rivalry of competitors Oligopoly – interdependence of major players Firms tend to imitate each other’s FDI Match each other’s moves to hold each other in check

Pattern of FDI Raymond Vernon - Product Life cycle Firms undertake FDI at particular stages in the life cycle of a product that they have pioneered in their home market Invest in other countries when local demand is large enough to support local production Shift production to developing countries when product standardization and market saturation give rise to price competition and cost pressure.

Eclectic Paradigm British economist John Dunning In addition to theories of patterns of trade - Location specific advantages important in explaining rationale for and direction of FDI Combining location specific assets or resource endowments & the firm’s own unique technological or management capabilities often requires FDI

Political Ideology & FDI Radical view - MNE is instrument of imperialist domination Exploit host country for benefit of home country Keeps developing countries backward & dependent on capitalist nations for investment, jobs & technology Extract profits & give nothing of value to host country Important jobs go to home country nationals

Political Ideology & FDI Free Market View – Adam Smith & David Ricardo Theory of comparative advantage Countries should specialize in the production of those goods & services they can produce most efficiently MNE is instrument for dispersing production to the most efficient locations around the globe FDI resource transfers benefit the host country & stimulate its economic growth

Political Ideology & FDI Pragmatic Nationalism – FDI has both benefits & costs Benefit a host country with capital, skills, technology, & jobs Costs to host country in terms of repatriation of profits and importing of components FDI should be allowed if the benefits outweigh the costs

FDI Benefits Host Country Resource transfer effects Supplying capital, technology & management resources Employment effects Brings jobs directly by MNE employing & indirectly by suppliers employing MNE tend to pay higher wages Balance of payment effects Tracks payments to & receipts from other countries FDI can substitute for imports, & can export to other countries Effects on competition & economic growth Green-field increases the number of players, increase competition Competition drive down prices & benefit consumers Increased productivity, innovation & economic growth

FDI Costs Host Country Adverse effects on competition MNE subsidiaries may have greater economic power than indigenous firms Adverse effects on balance of payments Too much outflow so restrict the amount that can be repatriated Too much importing of components vs local sourcing Perceived loss of national sovereignty Key decisions that effect host economy will be made by foreign parent with no commitment to & no control by host country

FDI Benefits Home Country Inward flow of foreign earnings May also create demand for home country exports of equipment & goods Employment effects Jobs created by demand for exports MNE learns valuable skills that can be transferred back reverse resource-transfer contributing to home country economic growth rate

FDI Costs Home Country Balance of payments Suffers from initial capital outflow to finance FDI Suffers if purpose to supply home market from low-cost production location Suffers if the FDI is substitute for direct exports Employment effects Suffers when FDI is substitute for domestic production – reduced home country employment

FDI & Government Policy Home Country Policies for encouraging outward FDI Foreign risk insurance Risks of expropriation (nationalization) War losses Inability to transfer profits back home Capital assistance Special funds or banks to make government loans to encourage domestic firms to undertake FDI Tax incentives Eliminate double taxation of foreign income (host & home governments) Political pressure Use political influence to encourage host countries to reduce FDI restrictions

FDI & Government Policy Home Country Restricting Outward FDI Limit capital outflows out of concern for the balance of payments Manipulated tax rules to encourage their firms to invest at home – create jobs at home Countries sometimes prohibit national firms from investing in certain countries for political reasons. (Cuba, South Africa)

FDI & Government Policy Host Country Encouraging inward FDI Offer incentives for foreign firms to invest in their countries Tax concessions Low-interest loans New state spending on infrastructure Grants or subsidies Desire to gain from the resource transfer and employment effects Desire to capture FDI away from other potential host countries

FDI & Government Policy Host Country Restricting inward FDI Ownership restraints Foreign companies excluded from specific fields – national security or competition (infant industry) Significant proportion of the equity of the subsidiary must be owned by local investors – maximize resource-transfer & employment benefits Performance requirements Maximize the benefits and minimize the costs Related to local content, exports, technology transfer & local participation by top management

International Institutions & FDI WTO Embraces the promotion of trade in services Many services need to be produced where they are sold Push for the liberalization of FDI particularly in services Less successful in establishing universal rules with regards to FDI

Managerial Implications Relative profitability of FDI, exporting & licensing vary with circumstances As transport costs & trade barriers increase, FDI or licensing are better Licensing not best when have valuable know-how or need tight control Host governments attitude toward FDI important variable in where to locate production