1. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

2. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. CHAPTER Foreign Direct Investment

3. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Key Issues Why is FDI increasing? Why do firms choose FDI over exporting or licensing to enter a foreign market? Why are certain locations attractive for FDI? How does political ideology influence government policy over FDI? From a host or source country perspective, what are FDI’s costs and benefits? How can governments restrict/encourage FDI?

4. McGraw-Hill/Irwin © 2004 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

5. McGraw-Hill/Irwin © 2004 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

6. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. FDI Growth in the World Economy FDI Outflow of $25 billion in 1975 increased to $1.3 trillion in 2000 FDI flow accelerated more than world trade (x 5 and x 1.8 respectively) FDI Flow from all countries increased 1000%, trade 91%, world output 27% from 1984 to 1998 FDI Stock increased to $3.5 trillion by 1997 63,000 parent firms with 690,000 foreign affiliates produced $14 trillion sales, almost twice global exports FDI growing faster than world trade –Political risk issues –Economic reason issues –Globalization Slide 6-3

7. McGraw-Hill/Irwin © 2004 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 –1985-1990 Japan 1st, UK 2nd, US 3rd –Effect of ¥ increase in value In 2000 the USA received 21.6% of world FDI; the EU received 48.7% Slide 6-4

8. McGraw-Hill/Irwin © 2004 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

9. McGraw-Hill/Irwin © 2004 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

10. McGraw-Hill/Irwin © 2004 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 know-how –Capabilities not suitable for licensing/franchising Slide 6-7

11. McGraw-Hill/Irwin © 2004 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 (Vernon, see Ch. 4) Eclectic paradigm of FDI (John Dunning) –Combines ownership specific, location specific, and internalization specific advantages that drive FDI choice over a decision to enter through licensing or exports Slide 6-8

12. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 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

13. McGraw-Hill/Irwin © 2004 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

14. McGraw-Hill/Irwin © 2004 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

15. McGraw-Hill/Irwin © 2004 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 know-how Costs –BOP trade position is negatively affected (lower finished goods exports) –Loss of employment to overseas market Slide 6-12

16. McGraw-Hill/Irwin © 2004 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

17. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Decision Framework for FDI Are transportation costs high? Is know-how easy to license? Tight control over foreign ops required? Is know-how valuable and is protection possible? Export FDI License No Yes No Yes Import Barriers? No Yes Slide 6-14