1. Foreign Direct Investment
Lecture 4
Foreign Direct Investment
© Ram Mudambi, Temple University, 2007

2. 1. Foreign Direct Investment
2. The Political Economy of Foreign Direct Investment
© Ram Mudambi, Temple University, 2007

3. DaimlerChrysler – Group Sales by Region - 2004
Units in ‘000s
71.1%
West
Europe
20.5%
Japan
1.1%
9.9%
WORLD Total = 3,903
Germany
NAFTA US
62.3%
Is this an accurate picture of the firm’s global footprint?
© Ram Mudambi, Temple University, 2007

4. Mercedes – Group Sales by Region - 2004
Units in ‘000s
19.9%
West
Europe
66.6%
Japan
3.5%
32.2%
Germany
NAFTA US
18.5%
WORLD Total = 3,903
What is the unit value of Mercedes relative to Chrysler?
© Ram Mudambi, Temple University, 2007

5. What is Foreign Direct Investment (FDI)?
FDI occurs when a firm invests directly in facilities to produce and/or market a product or service in a foreign country.
FDI is not the investment by individuals, firms or public bodies in foreign financial instruments (PORTFOLIO INVESTMENT)
© Ram Mudambi, Temple University, 2007

6. FDI Taxonomy MODE Greenfield Acquisition Wholly-owned 1 3
A firm buying
a firm in
another country
FDI Taxonomy
MODE
Greenfield
Acquisition
Wholly-owned 1 3
Partially owned 2 4
A firm setting
up a de novo
operation in
another country
Targets
necessary
Controlling
interest
Minority
Mode of entry vs. control of entry
© Ram Mudambi, Temple University, 2007

7. Flow vs Stock of FDI
Flow: Amount of FDI over a period of time (one year).
Stock: Total accumulated value of foreign owned assets at a given point in time.
© Ram Mudambi, Temple University, 2007

8. FDI outflows,
© Ram Mudambi, Temple University, 2007

9. FDI flows by region
© Ram Mudambi, Temple University, 2007

10. FDI outflows by select country 1998-2001
© Ram Mudambi, Temple University, 2007

11. World GDP, exports and FDI
World GDP and FDI (index = 100 in 1990)
© Ram Mudambi, Temple University, 2007

12. FDI Growth > Trade growth > Output growth
Secular pattern
FDI Growth > Trade growth > Output growth

13. Gross Fixed Capital Formation
A summary of the total amount of capital invested in factories, stores office buildings, and the like.
All things being equal, the greater the capital investment in an economy, the more favorable its future growth prospects are likely to be.
© Ram Mudambi, Temple University, 2007

14. Inward FDI flows
As a percentage of gross fixed capital formation, 2000
© Ram Mudambi, Temple University, 2007

15. FDI Inflow for Selected Countries % of total capital investment, 2005
© Ram Mudambi, Temple University, 2007

16. Why is FDI growing more rapidly than world trade or output?
MACRO
Why is FDI growing more rapidly than world trade or output?
World political and
economic change
Wider acceptance
of MNC operations
Movement of operations to the
most efficient location
© Ram Mudambi, Temple University, 2007

17. Why is FDI growing more rapidly than world trade or output?
MICRO
Why is FDI growing more rapidly than world trade or output?
Growing power of regional
economic blocs
EU, NAFTA, Mercosur, etc.
Improved logistics
Strategy of extra-bloc
firms to become ‘domestic’
– ‘tariff-jumping’
Most international
trade is intra-firm
E.g., Dole in the EU banana case.
Movement of operations to the
most efficient location
© Ram Mudambi, Temple University, 2007

18. Two Forms of FDI HOST HOME Location 2 Stage 0 Backward Vertical FDI
Horizontal FDI
Value chain
Location 2
Stage 2
Forward
Vertical FDI
Horizontal FDI – the firm operates in the same industry in the host as at home
Vertical FDI – the firm operates in the same industry in the host as at home
Backward – typically into extractive industries
Forward – typically into sales and distribution
© Ram Mudambi, Temple University, 2007

19. FDI – composition changes
FDI been growing in terms of volume, but it has also been changing in its composition
Increasingly FDI represents a considerable amount of transfer of knowledge
Know-how and skills
Scientific knowledge
Organizational knowledge
Multinational firms do not like to give up control of this knowledge
© Ram Mudambi, Temple University, 2007

20. Impediments to the Sale of Know-how
Risk giving away know-how to competitors
Licensing implies low control over foreign entity
Impediments to the sale of know- how
Know-how not amenable to licensing
© Ram Mudambi, Temple University, 2001

21. HFDI, When and Why? Transportation too costly?
Most cited: Market Imperfections (Internalization Theory).
Impediments to the free flow of products between nations.
Impediments to the sale of know-how.
Follow the lead of a competitor - strategic rivalry.
Product Life Cycle - however, does not explain when it’s profitable to invest abroad.
Location specific advantages (natural resources).
© Ram Mudambi, Temple University, 2007

22. HFDI, Where? The Stage Theory of FDI
Firms first expand into host countries that are culturally close to the home country
British firms
US firms
US, Australia, New Zealand
Canada, Mexico
© Ram Mudambi, Temple University, 2007

23. The Stage Theory: Wal-Mart International
Wal-mart has since withdrawn
from Germany
© Ram Mudambi, Temple University, 2007

24. HFDI – A Decision Framework
How high are transportation costs and tariffs?
Low
Export
High
Is know-how amenable to licensing? No
Horizontal FDI
Yes
Is tight control over foreign operation required?
Yes
Horizontal FDI No
Can know-how be protected by licensing contract? No
Horizontal FDI
Yes
License

25. Case: FDI and the Irish miracle
FDI in Ireland grew from $164m (1985) to $24b (2000) (roughly 150 fold!)
By 2000 two-thirds of Irelands top exporters were MNEs
Reasons for Ireland’s success
Member of EU (access to EU markets)
Highly educated workforce; Good infrastructure
In 1985, Ireland was the 2nd poorest W.European country. Today it is the 2nd richest.
© Ram Mudambi, Temple University, 2007

26. FDI into China – Success story?
Second Largest Recipient of FDI After US
© Ram Mudambi, Temple University, 2007

27. Changing Face of China’s Foreign Investment
1992
2002
Joint Ventures
70%
48%
Wholly owned foreign subsidiaries
30%
52%
Source: McKinsey & Co
© Ram Mudambi, Temple University, 2007

28. FDI – China vs. the US High percentage from other developing countries
Largely greenfield
Largely asset seeking
Large amount of
‘round-tripping’
China
High percentage from
other developed
countries
Largely by acquisition
Largely market seeking
The US
Chinese data tend to show higher FDI figures for inflows from the US and Japan than US or Japanese data.
However, recently:
More market seeking FDI
More FDI from developed countries
© Ram Mudambi, Temple University, 2007

29. The Political Economy of Foreign Direct Investment
© Ram Mudambi, Temple University, 2007

30. The Spectrum of Political Ideology Toward FDI
Radical
View
Pragmatic
Nationalism
Free
Market
© Ram Mudambi, Temple University, 2007

31. Radical View
Marxist view is that MNE’s enslave less developed countries.
Instrument of domination not development.
Popular from WWII to the 1980s.
Practiced by Eastern Europe, India, China, 3rd World Countries.
Ended with the collapse of Communism.
Bad performance by those countries vs. those with freer market approach
© Ram Mudambi, Temple University, 2007

32. Free Market View
Sees FDI as way to disperse production and flow of goods and services in the most efficient manner.
Supported by Smith and Ricardo and ‘market imperfection’ explanations of FDI.
However, all countries impose some restrictions on FDI.
© Ram Mudambi, Temple University, 2007

33. Pragmatic View Lies somewhere between radical and free market views.
Governments should maximize national benefits and minimize costs of FDI.
© Ram Mudambi, Temple University, 2007

34. Pragmatic Nationalism
Ideology and FDI
Ideology
Characteristics
Host-Government Policy Implications
Radical
Marxist roots
Views FDI as an imperialist tool
Prohibit FDI
Nationalize MNC subsidiaries
Free Market
Classical economic roots
FDI as a tool for efficient location of operations
No restrictions on FDI
Pragmatic Nationalism
FDI has both benefits and costs
Court targeted MNCs
Tailor incentives
© Ram Mudambi, Temple University, 2007

35. What do the data tell us? – 1
MNC economic interests are overwhelmingly concentrated in the triad – North America, Europe and Japan/East Asia
There is no evidence that triad governments are subject to ‘control’ by MNCs
Competitive pressures cause MNCs to cancel each other out
Activities outside the triad are too insignificant to justify expense of political activities
E.g., a recent CIMA study found that most MNCs followed ‘whiter than white’ accounting practices
MNCs interact with governments, but are not powerful enough to pursue a political agenda (Brewer, 1995).
Triad governments and MNCs – e.g., my studies of FDI into Italy
‘White than white’ accounting is relevant to transfer pricing accusations.
MNCs practices are generally of higher standard than those of domestic competitors
E.g., wages, work conditions, etc.
© Ram Mudambi, Temple University, 2007

36. What do the data tell us? – 2
Globalization refers to FDI, not financial flows
FDI flows are extremely stable
MNC strategies tend to be regional, rather than global, reflecting regional trading blocs
Fears of global homogenization are over-rated
EU, NAFTA, Mercosur, APEC
MNCs tend to be “flagship firms” – serve as hubs of extensive business networks/clusters
Bartlett and Ghoshal – national differentiation, local adaptation
© Ram Mudambi, Temple University, 2007

37. Benefits of FDI to Host Countries
Resource-transfer effects
Capital, technology, management
Employment effects
Balance-of-payments effects
Economic growth
© Ram Mudambi, Temple University, 2007

38. FDI and resource-transfer effects
Inflow of capital
HOST
Subsidiary
HOME
Parent
Spillover of
technology
and
management
practices
© Ram Mudambi, Temple University, 2007

39. FDI and employment effects
Jobs created
in local
supplier &
ancillary
network
HOST
Subsidiary
Direct
local
jobs
created
Jobs lost in local
firms that are
driven out of
business
Jobs created due to increased
income generation
© Ram Mudambi, Temple University, 2007

40. FDI and balance of payments
Taxes, tariffs
and other
payments
to the govt.
(+)
Inflow of capital
(+)
HOST
Subsidiary
HOME
Parent
Local
output
replaces
imports
(+)
Subsidiary
exports
(+)
Repatriated
profits (-)
3rd Country
© Ram Mudambi, Temple University, 2007

41. Economic Growth Increased:
productivity growth,
product and process innovation,
and greater economic growth,
Stemming from increased competition of MNE’s investments.
© Ram Mudambi, Temple University, 2007

42. How Do Countries Encourage FDI?*
Risk insurance.(Home)
Elimination of double taxation. (Home)
Tax incentives.(Host)
Low interest rates. (Host)
Grants for land and training of workforce (Host)
Stable government and stable policies (Host)
*See
© Ram Mudambi, Temple University, 2007

43. How Do Countries Discourage FDI?
Limit capital outflows. (Home)
Manipulate tax code to encourage domestic investment. (Home)
Political restrictions on investing in certain countries. (Home)
Ownership restraints. (Host)
Performance requirements. (Host)
© Ram Mudambi, Temple University, 2007

44. Vernon’s Obsolescing Bargain: Determinants of Bargaining Power
Bargaining Power of Firm
High
Low
Firms time horizon
Long
Short
Comparable alternatives open to firm
Many
Few
Value placed by host government on investment
Low
High
© Ram Mudambi, Temple University, 2007

45. Takeaways FDI has been rising faster than GDP or trade
Rising power of regional blocs; better logistics
HFDI – customization
VFDI – value chain disaggregation
FDI as a powerful economic stimulant
Examples – Ireland, China
Pragmatic view of MNEs – use with care
Potential benefits of FDI
Resource transfer, employment, BOP, growth
© Ram Mudambi, Temple University, 2007