Foreign Direct Investment 7

7 - 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

7 - 3 Volkswagen Produces 8 million cars a year Modular production strategy Special protection in Germany

7 - 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  By contrast, portfolio investment does not involve obtaining a degree of control in a company

7 - 5 Yearly FDI Inflows Source: Based on World Investment Report (Geneva, Switzerland: UNCTAD), various years.

7 - 6 Reasons for FDI Growth Increasing globalization International mergers and acquisitions

7 - 7 Value of Cross-Border M&As Source: Based on World Investment Report (Geneva, Switzerland: UNCTAD), various years.

7 - 8 Worldwide FDI Flows World FDI inflows  Developed (49%), developing (45%)  European Union: 28% of world FDI Developing nations  China and India attract most FDI  All of Africa: 2.8% of world FDI 82,000 multinationals with 810,000 affiliates

7 - 9 Discussion Question What is the difference between foreign direct investment and portfolio investment?

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.

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 Source: Raymond Vernon and Louis T. Wells, Jr., The Economic Environment of International Business, 5 th ed. (Upper Saddle River, N.J.: Prentice Hall, 1991), p

Market Imperfections (Internalization)  Trade barriers (e.g., tariffs)  Unique advantage (e.g., special knowledge) A company undertakes FDI to internalize a transaction that is made inefficient because of a market imperfection

Eclectic Theory FDI when location, ownership, and internalization advantages combine to make a location appealing Location advantage (optimal location) Ownership advantage (special asset) Internalization advantage (efficiency)

Market Power FDI used to establish a dominant presence in an industry Vertical integration Extends company’s activities into stages of production that provide its inputs (backward integration) or absorb its out- puts (forward integration) Market power = Greater profits

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

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

Management Issues I Control Purchase-or-build

Management Issues II Production costs Customer knowledge Source: LIU JIN/Newscom

Management Issues III Following rivals Following clients

Balance of Payments Capital accountCurrent account National accounting system that records all payments to entities in other countries and all receipts coming into the nation The import and export of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country The purchase or sale of assets (including assets such as property and shares of common stock in a company)

U.S. Balance of Payments

Discussion Question What do we mean by a country’s balance of payments and what is its usefulness?

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.

Host Intervention I Balance of Payments + Balance of Payments + FDI may generate exports Initial FDI boosts economy FDI may decrease imports

Host Intervention II Obtain resources and benefits + Obtain resources and benefits + Access technology Access management skills Create employment

Home Intervention + Improve competitiveness + Eliminate low-wage jobs – Remove national resources – Eliminate export markets – Eliminate domestic jobs

Host Promotion Methods Financial incentives ■ Low or waived taxes ■ Low-interest loans Infrastructure benefits ■ Better seaports, roads, and telecom networks

Host Restriction Methods Ownership restrictions ■ Prohibit investment in industries or businesses Performance demands ■ Local content requirements ■ Export targets ■ Technology transfers

Home Promotion Methods Insurance on assets abroad Loans and loan guarantees Tax breaks on profits earned abroad Special tax treaties Persuade other nations to accept FDI

Home Restriction Methods Higher taxes on foreign income Sanctions that prohibit investing

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

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