2Foreign Direct Investment Chapter 7Foreign Direct Investment
3IntroductionForeign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign countryOnce a firm undertakes FDI it becomes a multinational enterpriseFDI can be:greenfield investments - the establishment of a wholly new operation in a foreign countryacquisitions or mergers with existing firms in the foreign countryGreenfield operation:Mostly in developing nationsMergers and acquisitions:Quicker to executeForeign firms have valuable strategic assetsBelieve they can increase the efficiency of the acquired firmMore prevalent in developed nations
4Classroom Performance System The establishment of a wholly new operation in a foreign country is calledA) an acquisitionB) a mergerC) a greenfield investmentD) a multinational ventureThe answer is c.
5Foreign Direct Investment In The World Economy The flow of FDI refers to the amount of FDI undertaken over a given time periodThe stock of FDI refers to the total accumulated value of foreign-owned assets at a given timeOutflows of FDI are the flows of FDI out of a countryInflows of FDI are the flows of FDI into a country
6Classroom Performance System The amount of FDI undertaken over a given time period is known asA) the flow of FDIB) the stock of FDIC) FDI outflowD) FDI inflowThe answer is a.
7Trends In FDIThere has been a marked increase in both the flow and stock of FDI in the world economy over the last 30 yearsFDI has grown more rapidly than world trade and world output because:firms still fear the threat of protectionismthe general shift toward democratic political institutions and free market economies has encouraged FDIthe globalization of the world economy is having a positive impact on the volume of FDI as firms undertake FDI to ensure they have a significant presence in many regions of the world
9The Direction Of FDIMost FDI has historically been directed at the developed nations of the world, with the United States being a favorite targetFDI inflows have remained high during the early 2000s for the United States, and also for the European UnionSouth, East, and Southeast Asia, and particularly China, are now seeing an increase of FDI inflowsLatin America is also emerging as an important region for FDICountry Focus: Foreign Direct Investment in ChinaSummaryThis feature explores investment opportunities in China. In the late 1970s, China opened its doors to foreign investors. By the mid 2000s, China attracted $60 billion of FDI annually. China’s large population is a magnet for many companies and because high tariffs make it difficult to export to the Chinese market, firms frequently turn to foreign direct investment. However, many companies have found it difficult to conduct business in China, and in recent years investment rates have slowed. In response, the Chinese government, hoping to continue to attract foreign companies has established a number of incentives for would-be investors. The following questions can be used in a discussion.1. Consider the challenges involved with investing in China. How does China’s political position and economic situation affect its ability to attract foreign direct investment?Discussion Points: Students will probably recognize that while on the surface, China has tremendous market potential, it is still a poor country. Anticipated demand does not always translate into actual demand. In addition, thanks to the country’s lack of a well-developed transportation system, distribution problems continue to exist, particularly outside major urban areas. In addition, the country’s highly regulated environment makes it difficult for companies to conduct business.2. Discuss China’s efforts to encourage investment in its underdeveloped areas. What effect will investment have on these areas? How can firms prepare for the unique challenges of operating in these areas?Discussion Points: China is making a concerted effort to continue to attract investment, especially in the country’s less developed areas. Recognizing the problems associated with its infrastructure, the country has committed $800 billion to improvements over the next decade. In addition, China is offering preferential tax breaks to countries that invest in more remote areas.
10Figure 7.3: FDI Inflows by Region ($ billion), 1995-2006 The Direction Of FDIFigure 7.3: FDI Inflows by Region ($ billion),
11The Direction Of FDIGross fixed capital formation summarizes the total amount of capital invested in factories, stores, office buildings, and the likeAll else being equal, the greater the capital investment in an economy, the more favorable its future prospects are likely to beSo, FDI can be seen as an important source of capital investment and a determinant of the future growth rate of an economy
12The Direction Of FDIFigure 7.4: Inward FDI as a % of Gross Fixed Capital FormationThis Figure suggests that FDI has become increasingly important as a source of investment in the world’s economies.
13Classroom Performance System Most FDI is direct towarda) developed countriesb) emerging economiesc) the United Statesd) ChinaThe answer is a.
14The Source Of FDISince World War II, the U.S. has been the largest source country for FDIThe United Kingdom, the Netherlands, France, Germany, and Japan are other important source countries
15Figure 7.5: Cumulative FDI Outflows ($ billions), 1998-2005 The Source Of FDIFigure 7.5: Cumulative FDI Outflows ($ billions),
16The Form Of FDI: Acquisitions Versus Greenfield Investments Most cross-border investment is in the form of mergers and acquisitions rather than greenfield investmentsFirms prefer to acquire existing assets because:mergers and acquisitions are quicker to execute than greenfield investmentsit is easier and perhaps less risky for a firm to acquire desired assets than build them from the ground upfirms believe that they can increase the efficiency of an acquired unit by transferring capital, technology, or management skills
17The Shift To ServicesFDI is shifting away from extractive industries and manufacturing, and towards servicesThe shift to services is being driven by:the general move in many developed countries toward servicesthe fact that many services need to be produced where they are consumeda liberalization of policies governing FDI in servicesthe rise of Internet-based global telecommunications networks
18Theories Of Foreign Direct Investment Why do firms invest rather than use exporting or licensing to enter foreign markets?Why do firms from the same industry undertake FDI at the same time?How can the pattern of foreign direct investment flows be explained?
19Why Foreign Direct Investment? Why do firms choose FDI instead of:exporting - producing goods at home and then shipping them to the receiving country for saleorlicensing - granting a foreign entity the right to produce and sell the firm’s product in return for a royalty fee on every unit that the foreign entity sells
20Why Foreign Direct Investment? An export strategy can be constrained by transportation costs and trade barriersForeign direct investment may be undertaken as a response to actual or threatened trade barriers such as import tariffs or quotas
21Why Foreign Direct Investment? Internalization theory (also known as market imperfectionstheory) suggests that licensing has three major drawbacks:licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitorlicensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitabilitya problem arises with licensing when the firm’s competitive advantage is based not so much on its products as on the management, marketing, and manufacturing capabilities that produce those productsFDI is more attractive when transportation costs or trade barriers make exporting unattractive.A firm will favor FDI over licensing when it wishes to maintain control over its technological know-how, or over its operations and business strategy, or when the firm’s capabilities are simply not amenable to licensing.With regard to horizontal FDI, market imperfections arise in two circumstances:When there are impediments to the free flow of products between nations which decrease the profitability of exporting relative to FDI and licensingWhen there are impediments to the sale of know-how which increase the profitability of FDI relative to licensing
22The Pattern Of Foreign Direct Investment Firms in the same industry often undertake foreign direct investment around the same time and tend to direct their investment activities towards certain locationsKnickerbocker looked at the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms) and suggested that FDI flows are a reflection of strategic rivalry between firms in the global marketplaceThe theory can be extended to embrace the concept of multipoint competition (when two or more enterprises encounter each other in different regional markets, national markets, or industries)FDI is expensive because a firm must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign enterprise.FDI is risky because of the problems associated with doing business in another culture where the rules of the game may be different.
23The Pattern Of Foreign Direct Investment Vernon argued that firms undertake FDI at particular stages in the life cycle of a product they have pioneeredFirms invest in other advanced countries when local demand in those countries grows large enough to support local production, and then shift production to low-cost developing countries when product standardization and market saturation give rise to price competition and cost pressuresVernon fails to explain why it is profitable for firms to undertake FDI rather than continuing to export from home base, or licensing a foreign firm
24The Pattern Of Foreign Direct Investment According to the eclectic paradigm, in addition to the various factors discussed earlier, it is important to consider:location-specific advantages - that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assetsandexternalities - knowledge spillovers that occur when companies in the same industry locate in the same area
25Classroom Performance System Advantages that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets area) First mover advantagesb) Location advantagesc) Externalitiesd) Proprietary advantagesThe answer is b.
26Political Ideology And Foreign Direct Investment Ideology toward FDI ranges from a radical stance that is hostile to all FDI to the non-interventionist principle of free market economiesBetween these two extremes is an approach that might be called pragmatic nationalism
27The Radical ViewThe radical view traces its roots to Marxist political and economic theoryIt argues that the MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countriesThis position lacked support by the end of the 1980s because of:the collapse of communism in Eastern Europethe poor economic performance of those countries that followed the policya growing belief by many of these countries that FDI can be an important source of technology and jobs and can stimulate economic growththe strong economic performance of developing countries that embraced capitalism rather than ideology
28The Free Market ViewAccording to the free market view, international production should be distributed among countries according to the theory of comparative advantageThe free market view has been embraced by a number of advanced and developing nations, including the United States, Britain, Chile, and Hong Kong
29Pragmatic Nationalism Pragmatic nationalism suggests that FDI has both benefits, such as inflows of capital, technology, skills and jobs, and costs, such as repatriation of profits to the home country and a negative balance of payments effectAccording to this view, FDI should be allowed only if the benefits outweigh the costs
30Shifting IdeologyRecently, there has been a strong shift toward the freemarket stance creating:a surge in FDI worldwidean increase in the volume of FDI in countries with newly liberalized regimesManagement Focus: DP World and the United StatesSummaryThis feature explores the reaction to the bid by DP World, a Dubai-based ports operator, to acquire P&O, a British firm that runs a network of global marine terminals. An acquisition of P&O would give DP World management of six U.S. ports. While the Bush administration claimed the acquisition posed no threat to national security, several prominent U.S. Senators raised concerns about the acquisition. Ultimately, DP World pulled out of the deal, but stated that it would look for alternative ways to enter the U.S. market. The following questions can be used in a discussion.Suggested Discussion Questions1. Do you agree with the senators who raised concerns about the DP World deal? Why or why not? Would your response be different if DP World were a British firm?Discussion Points: This issue will probably generate significant debate among students. At the heart of the issue is whether a company, because of its country of origin, should be denied ownership of something that could be important to a nation’s national security. Some students will probably argue that the U.S. was unjustified in its reaction to the deal, that DP World has a long history of American associations. Students taking this perspective will probably suggest that the U.S. is being prejudiced against the company simply because of its nationality. Other students however, will probably claim that DP World’s role in with American companies to date, has not involved ownership of ports that could be important to the country’s national security. Students in this camp will probably argue that the ports should be owned by American companies, or at least companies from countries that are allies of the United States in order to preserve national security, but definitely not a state-owned company from the Middle East. The implication here is that ownership of the ports would effectively transfer to a foreign government.2. DP World has vowed to enter the U.S. market in some other way. Why is the U.S. market so important to DP World? What do you think the response of the government might be to another attempt by DP World?Discussion Points: The U.S. market is important to DP World because it is an epicenter of capitalism. Goods from all over the world flow to the United States, and DP World wants to be in a position to capitalize on this. Students will probably agree that should the company make another attempt to gain a foothold in the market, the United States will be reluctant to allow DP World a significant role in the country, especially in major ports.
31Benefits And Costs Of FDI Government policy is often shaped by a consideration of the costs and benefits of FDI
32Host-Country Benefits There are four main benefits of inward FDI for a hostcountry:1. resource transfer effects - FDI can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available2. employment effects - FDI can bring jobs to a host country that would otherwise not be created there
33Host-Country Benefits 3. balance of payments effects - a country’s balance-of-payments account is a record of a country’s payments to and receipts from other countries.The current account is a record of a country’s export and import of goods and servicesGovernments typically prefer to see a current account surplus than a deficitFDI can help a country to achieve a current account surplus if the FDI is a substitute for imports of goods and services, and if the MNE uses a foreign subsidiary to export goods and services to other countries
34Host-Country Benefits 4. effects on competition and economic growth - FDI in the form of greenfield investment increases the level of competition in a market, driving down prices and improving the welfare of consumersIncreased competition can lead to increased productivity growth, product and process innovation, and greater economic growth
35Classroom Performance System Benefits of FDI include all of the following excepta) The resource transfer effectb) The employment effectc) The balance of payments effectd) National sovereignty and autonomyThe answer is d.
36Host-Country Costs Inward FDI has three main costs: 1. the possible adverse effects of FDI on competition within the host nationsubsidiaries of foreign MNEs may have greater economic power than indigenous competitors because they may be part of a larger international organization
37Host-Country Costs 2. adverse effects on the balance of payments with the initial capital inflows that come with FDI must be the subsequent outflow of capital as the foreign subsidiary repatriates earnings to its parent countrywhen a foreign subsidiary imports a substantial number of its inputs from abroad, there is a debit on the current account of the host country’s balance of payments
38Host-Country Costs3. the perceived loss of national sovereignty and autonomykey decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control
39Home-Country Benefits The benefits of FDI for the home country include:the effect on the capital account of the home country’s balance of payments from the inward flow of foreign earningsthe employment effects that arise from outward FDIthe gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country
40Home-Country Costs The home country’s balance of payments can suffer: from the initial capital outflow required to finance the FDIif the purpose of the FDI is to serve the home market from a low cost labor locationif the FDI is a substitute for direct exportsEmployment may also be negatively affected if the FDI is a substitute for domestic production
41Classroom Performance System Which of the following is not a cost of outward FDI for host countries?a) the initial capital outflow required to finance the FDIb) when FDI is a substitute for direct exportsc) gains from learning valuable skills from foreign marketsd) the effect on employment is FDI is a substitute for domestic productionThe answer is c.
42International Trade Theory And FDI International trade theory suggests that home country concerns about the negative economic effects of offshore production (FDI undertaken to serve the home market) may not be valid
43Government Policy Instruments And FDI Home countries and host countries use various policies to regulate FDI
44Home-Country Policies Governments can encourage and restrict FDI:To encourage outward FDI, many nations now have government-backed insurance programs to cover major types of foreign investment riskTo restrict outward FDI, most countries, including the United States, limit capital outflows, manipulate tax rules, or outright prohibit FDI
45Host-Country Policies Governments can encourage or restrict inward FDITo encourage inward FDI, governments offer incentives to foreign firms to invest in their countriesIncentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI, and to capture FDI away from other potential host countriesTo restrict inward FDI, governments use ownership restraints and performance requirementsThe rationale underlying ownership restraints is twofold:first, foreign firms are often excluded from certain sectors on the grounds of national security or competitionsecond, ownership restraints seem to be based on a belief that local owners can help to maximize the resource transfer and employment benefits of FDI for the host country
46International Institutions And The Liberalization Of FDI Until the 1990s, there was no consistent involvement by multinational institutions in the governing of FDIToday, the World Trade Organization is changing this by trying to establish a universal set of rules designed to promote the liberalization of FDI
47Implications For Managers What are the implications of foreign direct investment for managers?Managers need to consider what trade theory implies, and the link between government policy and FDI
48The Theory Of FDIThe direction of FDI can be explained through the location-specific advantages argument associated with John DunningHowever, it does not explain why FDI is preferable to exporting or licensing
49Government PolicyA host government’s attitude toward FDI is an important variable in decisions about where to locate foreign production facilities and where to make a foreign direct investment