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Foreign Direct Investment

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1 Foreign Direct Investment
7 Foreign Direct Investment Welcome to Chapter 7, Foreign Direct Investment. Copyright © 2014 Pearson Education, Inc.

2 Chapter Objectives Describe worldwide patterns of foreign direct investment (FDI) and reasons for those patterns Describe each of the theories that attempt to explain why FDI occurs Discuss the important management issues in the FDI decision Explain why governments intervene in the free flow of FDI Discuss the policy instruments that governments use to promote and restrict FDI In this chapter, you will explore foreign direct investment. You will also: Learn about worldwide patterns of foreign direct investment flows and the theories that attempt to explain them. Understand important management issues in the foreign direct investment decision. And examine why governments intervene in the flow of foreign direct investment and the methods they use. Copyright © 2014 Pearson Education, Inc.

3 Volkswagen Produces 8 million cars a year Modular production strategy
Special protection in Germany From 48 facilities worldwide, the Volkswagen Group produces around eight million cars annually and sells them in more than 150 countries. A modular production strategy lets Volkswagen use the same key components across 16 different vehicles. The strategy cuts production and parts costs by 20 percent and reduces production time by 30 percent. Volkswagen, like companies everywhere, received help in getting where it is today. Until recently, a special law allowed the German state of Lower Saxony to block any takeover attempt that threatened local jobs and the economy. Volkswagen’s special treatment lies in the close ties between government and management in Germany and its importance to the nation’s economy. Copyright © 2014 Pearson Education, Inc. 7 - 3 3

4 Foreign Direct Investment (FDI)
Purchase of physical assets or significant amount of ownership of a company in another country in order to gain some measure of management control Foreign direct investment is the purchase of physical assets or a significant amount of the ownership of a company in another country in order to gain some measure of management control. It differs from portfolio investment, which does not involve obtaining control in a company. Most governments set the FDI threshold at somewhere between 10 and 25 percent of stock ownership in a company abroad. The U.S. Commerce Department says that stock ownership above 10 percent constitutes FDI. By contrast, portfolio investment does not involve obtaining a degree of control in a company Copyright © 2014 Pearson Education, Inc.

5 Yearly FDI Inflows Yearly FDI inflows peaked at an all-time high of $1.9 trillion in 2007. The global credit crisis then caused lower FDI flows in 2008 and 2009. Following the credit crisis and the global recession that followed, healthy companies are driving FDI higher once again. Source: Based on World Investment Report (Geneva, Switzerland: UNCTAD), various years. Copyright © 2014 Pearson Education, Inc.

6 International mergers
Reasons for FDI Growth Increasing globalization International mergers and acquisitions One main driver behind global flows of foreign direct investment is increasing globalization. Globalization of the world economy encourages firms to use FDI as a way to create low-cost production bases. It also prompts multinationals from both advanced and emerging economies to buy businesses in other markets. Another driver is international mergers and acquisitions. Mergers and acquisitions have propelled long-term growth in FDI and will likely do so for the foreseeable future. Copyright © 2014 Pearson Education, Inc.

7 Value of Cross-Border M&As
International mergers and acquisitions rise and fall from year to year and tend to follow the health of national economies. Many cross-border mergers and acquisitions are intended to: Get a foothold in a new geographic market. Increase a firm’s global competitiveness. Fill gaps in companies’ product lines in a global industry. And reduce the cost of research and development, production, or distribution. Source: Based on World Investment Report (Geneva, Switzerland: UNCTAD), various years. Copyright © 2014 Pearson Education, Inc.

8 Worldwide FDI Flows World FDI inflows Developing nations
Developed (49%), developing (45%) European Union: 28% of world FDI 82,000 multinationals Developing nations China and India attract most FDI All of Africa: 2.8% of world FDI More than 82,000 multinational companies with over 810,000 affiliates drive global FDI flows. Developed countries account for about 49% of all world FDI—the main recipients being the European Union, the United States, and Japan. Developing and emerging markets account for about 45% of global FDI, with the largest portions going to China and India. Outflows of FDI from emerging economies are also on the rise. with 810,000 affiliates Copyright © 2014 Pearson Education, Inc.

9 Discussion Question What is the difference between foreign direct investment and portfolio investment? What is the difference between foreign direct investment and portfolio investment? Copyright © 2014 Pearson Education, Inc.

10 Answer to Discussion Question
Foreign direct investment is the purchase of physical assets or a significant amount of the ownership of a company in another country to gain a measure of management control. Portfolio investment does not involve obtaining a degree of control in a company. Answer: Foreign direct investment is the purchase of physical assets or a significant amount of the ownership of a company in another country to gain a measure of management control. Portfolio investment is one that does not involve obtaining a degree of control in a company. Copyright © 2014 Pearson Education, Inc.

11 International Product Life Cycle
A company begins by exporting its product and later undertakes foreign direct investment as a product moves through its life cycle The international product life cycle theory states that a company will begin exporting its product and later undertake foreign direct investment as the product moves through its life cycle. In stage 1, the new product stage, high purchasing power and buyer demand encourage a company to design and introduce a new product concept. Although there is virtually no export market initially, exports increase late in this stage. In stage 2, the maturing product stage, the domestic market and markets abroad become fully aware of the existence of the product and its benefits. Demand rises and is sustained over a fairly lengthy period of time. Near the end of this stage, sales begin in developing nations and manufacturing is established there. In stage 3, the standardized product stage, competition from companies selling similar products pressures companies to lower prices to maintain sales levels. A search for low-cost production bases abroad begins and the home market may begin importing the product. Source: Raymond Vernon and Louis T. Wells, Jr., The Economic Environment of International Business, 5th ed. (Upper Saddle River, N.J.: Prentice Hall, 1991), p. 85. Copyright © 2014 Pearson Education, Inc. 7 - 11 11

12 Market Imperfections (Internalization)
A company undertakes FDI to internalize a transaction that is made inefficient because of a market imperfection Trade barriers (e.g., tariffs) Unique advantage (e.g., special knowledge) The market imperfections (or internalization) theory states that when an imperfection in the market makes a transaction less efficient than it could be, a company will undertake FDI to internalize the transaction and thereby eliminate the imperfection. One type of market imperfection is a trade barrier, such as a tariff. Another type of imperfection is a company’s unique competitive advantage, such as specialized knowledge, technical expertise, or special abilities embodied in employees. Copyright © 2014 Pearson Education, Inc.

13 Eclectic Theory FDI when location, ownership, and internalization advantages combine to make a location appealing The eclectic theory states that firms undertake foreign direct investment when the features of a location combine with ownership and internalization advantages to make a location appealing for investment. A location advantage is the advantage of locating a particular economic activity in a specific location because of its natural or acquired characteristics. An ownership advantage is a company advantage that arises from ownership of some special asset, such as a powerful brand, technical knowledge, or management ability. And an internalization advantage is the advantage that arises from internalizing a business activity rather than leaving it to a relatively inefficient market. Location advantage (optimal location) Ownership advantage (special asset) Internalization advantage (efficiency) Copyright © 2014 Pearson Education, Inc.

14 FDI used to establish a dominant presence in an industry
Market Power FDI used to establish a dominant presence in an industry Market power = Greater profits Vertical integration Extends company’s activities into stages of production that provide its inputs (backward integration) or absorb its out-puts (forward integration) The market power theory states that a firm tries to establish a dominant market presence in an industry by undertaking foreign direct investment. The benefit of market power is increased profits because greater power helps a firm to dictate the cost of its inputs and/or the price of its output. Companies can gain market power through vertical integration—the extension of activities into production that provide a firm’s inputs or absorb its output. Copyright © 2014 Pearson Education, Inc.

15 Discussion Question The eclectic theory says that firms undertake FDI when location, ownership, and __________ advantages combine to make a location appealing for investment. a. Internalization b. First-mover c. Life-cycle The eclectic theory says that firms undertake FDI when location, ownership, and __________ advantages combine to make a location appealing for investment. a. Internalization b. First-mover c. Life-cycle Copyright © 2014 Pearson Education, Inc.

16 Answer to Discussion Question
The eclectic theory says that firms undertake FDI when location, ownership, and __________ advantages combine to make a location appealing for investment. a. Internalization b. First-mover c. Life-cycle The correct answer is a. Internalization Copyright © 2014 Pearson Education, Inc.

17 Management Issues I Control Purchase-or-build
Although a company may invest abroad to increase its control in a local market, shared ownership also has advantages. Companies benefit from better communication with local government officials. Host countries benefit from worker and industry protection and more control over worker training and technology transfers. The purchase-or-build decision entails deciding whether to purchase an existing business or to build a subsidiary fresh from the ground up. Benefits of purchasing a firm include the existing company’s goodwill in the marketplace, brand recognition, and access to financing. Drawbacks of purchasing existing facilities can include obsolete equipment, poor labor relations, and an unsuitable location. Building a new subsidiary can involve drawbacks such as obtaining the necessary permits, arranging financing, and recruiting local personnel. Copyright © 2014 Pearson Education, Inc.

18 Source: LIU JIN/Newscom
Management Issues II Production costs Customer knowledge Production costs are important inputs to the FDI decision. Some prominent costs include worker benefits, employee training programs, and burdensome regulations. Lower research and development costs can encourage FDI but these costs can be outweighed by supply factors, such as access to top scientists and technical experts. Knowledge of customer and buyer behavior can be a key issue in the decision of whether to undertake FDI. A local presence can give companies valuable knowledge of customers that is unobtainable in the home market. Source: LIU JIN/Newscom Copyright © 2014 Pearson Education, Inc.

19 Management Issues III Following clients Following rivals
The practice of following clients into markets abroad typically occurs when suppliers of component parts have close working relationships with their customers. FDI puts the supplier nearer their customers where they can better understand and anticipate their needs. The practice of following rivals resembles a “follow the leader” scenario and is common in industries with a limited number of large firms. FDI is driven by a belief that not matching rivals’ moves can mean losing a “first mover” advantage or being shut out of a lucrative market altogether. Copyright © 2014 Pearson Education, Inc.

20 Balance of Payments National accounting system that records all payments to entities in other countries and all receipts coming into the nation Current account Capital account The purchase or sale of assets (including assets such as property and shares of common stock in a company) The import and export of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country A balance of payments is a national accounting system that records all payments to entities in other countries and all receipts coming into the nation. The current account records transactions involving the import and export of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country. The capital account records transactions involving the purchase or sale of assets. These assets include physical assets such as foreign direct investments in factories and equipment, and financial assets such as shares of stock in a company abroad. Copyright © 2014 Pearson Education, Inc.

21 U.S. Balance of Payments This table shows the U.S. balance of payments position for one recent year. Financial receipts from other nations are additions to the balance of payments accounts and recorded with a plus (+) sign. Payments to entities in other nations are reductions in the balance of payments accounts and recorded with a minus (–) sign. Copyright © 2014 Pearson Education, Inc.

22 Discussion Question What do we mean by a country’s balance of payments and what is its usefulness? What do we mean by a country’s balance of payments and what is its usefulness? Copyright © 2014 Pearson Education, Inc.

23 Answer to Discussion Question
A country’s balance of payments is a national accounting system that records all payments to entities in other countries and all receipts coming into the nation. The system helps monitor a country’s flows of goods, services, income, and asset transfers between itself and other nations. The balance of payments position sends warning signals about trade deficits with other nations. Answer: A country’s balance of payments is a national accounting system that records all payments to entities in other countries and all receipts coming into the nation. The system helps monitor a country’s flows of goods, services, income, and asset transfers between itself and other nations. The balance of payments position sends warning signals about trade deficits with other nations. Copyright © 2014 Pearson Education, Inc.

24 Host Intervention I + Balance of Payments Initial FDI boosts economy
FDI may generate exports Initial FDI boosts economy FDI may decrease imports Host countries get a balance-of-payments boost from initial FDI inflows. The host’s balance-of-payments increases further if the FDI produces goods for export. When a company repatriates profits back to its home market, the host nation’s foreign exchange reserves are reduced and the balance of payments declines. This entices some host nations to restrict foreign firms from repatriating profits. By contrast, a host country conserves its foreign exchange reserves when foreign companies reinvest earnings locally. This boosts the host nation’s exports and improves its balance-of-payments position. Copyright © 2014 Pearson Education, Inc.

25 Access management skills
Host Intervention II Obtain resources and benefits + Access technology Access management skills Create employment Host countries also intervene in FDI to obtain resources and benefits. Encouraging FDI in new technological products and processes increases host country competitiveness and productivity. A host country can also obtain management skills and employment benefits if the FDI involves technical training of locals in how to operate facilities. Some of those managers may go on to establish their own homegrown businesses. In general, inflows of FDI tend to increase economic output and enhance standards of living in a host country. Copyright © 2014 Pearson Education, Inc.

26 Home Intervention Remove national resources Eliminate export markets
Eliminate domestic jobs Home countries may discourage outward FDI for several reasons: Investing in other nations sends resources out of the home country and lowers investment at home. An FDI outflow can damage a nation’s balance of payments if the investment abroad eliminates an export market. And jobs created abroad by an FDI outflow may replace jobs in the home country. Home countries may also promote outward FDI. FDI outflows can improve long-run competitiveness if partnering abroad provides a learning opportunity. FDI outflows can eliminate low-wage jobs in industries that use obsolete technology or employ low-skilled workers at home. Improve competitiveness Eliminate low-wage jobs Copyright © 2014 Pearson Education, Inc.

27 Host Promotion Methods
Financial incentives Low or waived taxes Low-interest loans Infrastructure benefits Better seaports, roads, and telecom networks One method that host countries can use to promote FDI inflows are financial incentives. Tax incentives and/or low-interest loans to attract investment are common. But if bidding wars arise between locations competing for the investment, the cost of the FDI for taxpayers may be more than what the jobs actually pay. Other methods to promote FDI inflows include infrastructure improvements. Infrastructure improvements in the host country can include better seaports for containerized shipping, improved roads, and advanced telecommunications systems. Copyright © 2014 Pearson Education, Inc.

28 Host Restriction Methods
Ownership restrictions Prohibit investment in industries or businesses Performance demands Local content requirements Export targets Technology transfers One method that host countries can use to restrict FDI inflows are ownership restrictions. Governments can prohibit foreign companies from investing in certain industries or owning certain types of businesses. They may also require foreign investors to hold less than a 50% stake in a local firm. Other methods to restrict FDI inflows include performance demands. Such demands can dictate the portion of a product’s content that originates locally, stipulate that a portion of output must be exported, or demand that certain technologies be transferred to local businesses. Copyright © 2014 Pearson Education, Inc.

29 Home Promotion Methods
Insurance on assets abroad Loans and loan guarantees Special tax treaties To promote FDI outflows, home nations can: Offer insurance to cover the risks of investing company assets abroad. Grant loans to firms wishing to increase their investments abroad. Offer tax breaks on profits earned abroad or negotiate special tax treaties. And apply political pressure to get other nations to relax their restrictions on FDI inflows. Tax breaks on profits earned abroad Persuade other nations to accept FDI Copyright © 2014 Pearson Education, Inc.

30 Home Restriction Methods
Higher taxes on foreign income To restrict FDI outflows, home countries can: Impose a higher tax rate on income earned abroad than that levied on domestic earnings. And impose sanctions that prohibit domestic firms from making investments in certain nations. Sanctions that prohibit investing Copyright © 2014 Pearson Education, Inc.

31 Discussion Question A host government may encourage an initial FDI because the inflow can __________ its balance-of-payments position. a. Level b. Lower c. Boost A host government may encourage an initial FDI because the inflow can __________ its balance-of-payments position. a. Level b. Lower c. Boost Copyright © 2014 Pearson Education, Inc.

32 Answer to Discussion Question
A host government may encourage an initial FDI because the inflow can __________ its balance-of-payments position. a. Level b. Lower c. Boost The correct answer is c. Boost Copyright © 2014 Pearson Education, Inc.

33 Copyright © 2014 Pearson Education, Inc.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2014 Pearson Education, Inc.


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