FOREIGN DIRECT INVESTMENT AND ITS POLITICAL ECONOMY

FDI vs. FPI Foreign Direct Investment (FDI) occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country also occurs when a firm buys an existing enterprise in a foreign country Foreign Portfolio Investment (FPI) investment in foreign financial instruments (e.g. bonds/stocks) does not involve taking a significant equity stake in a foreign business entity

FDI Trends (Growth, Direction, Sources) Rapid increase in the total volume of FDI undertaken Slight decline in the relative importance of the US as a source of FDI; increase of FDI coming from other countries (especially Japan) Increasing share of FDI being directed at the developing nations of Asia and Eastern Europe Notable increase in the amount of FDI undertaken by firms based in developing nations

Exporting, Licensing, and FDI Impediments to Exporting: High transportation costs and trade barriers (e.g. tariffs, quotas) Impediments to Licensing (Sale of Know-how): A firm has valuable know-how that cannot be adequately protected by a licensing contract A firm needs tight control over a foreign entity to maximize its market share and earnings in that country A firm’s skill and know-how are not amenable to licensing

Horizontal vs. Vertical FDI Horizontal FDI FDI in the same industry abroad as a firm operates at home Vertical FDI FDI in an industry abroad that provides inputs into a firm’s domestic operations Backward Vertical FDI – provides inputs for a firm’s domestic production processes Forward Vertical FDI – sells the outputs of a firm’s domestic production processes

Horizontal FDI Transportation Costs – firms undertake FDI if transportation costs are too high Market Imperfections – firms undertake FDI if there are factors that inhibit markets from working perfectly (i.e. there are impediments to exporting and licensing) Strategic Behavior (F. T. Knickerbocker) – FDI is explained by imitative strategic behavior by rival firms in an oligopolistic industry Multipoint Competition – arises when 2 or more enterprises encounter each other in different regional markets, national markets, or industries

Product Life Cycle (Raymond Vernon) – firms undertake FDI at particular stages in the life cycle of a product they have pioneered (i.e. firms invest in advanced countries when demand in those countries can already support local production, and then invest in low-cost locations when cost pressures become intense) Location-Specific Advantages (John Dunning) – aside from the previously mentioned reasons, firms undertake FDI to exploit resource endowments or assets that are location-specific

Vertical FDI Strategic Behavior – firms vertically integrate backward to gain control over the source of raw material raises entry barriers and shuts new competitors out of an industry Market Imperfections – firms vertically integrate backward when there are impediments to the sale of know-how and there is a need to invest in specialized assets whose value depends on inputs provided by a foreign supplier

Political Ideology and FDI Radical View – sees the MNE as an imperialist tool for exploiting host countries; prohibits FDI and nationalizes subsidiaries of foreign-owned MNEs Pragmatic Nationalism – views FDI as having both benefits and costs; bargains for greater FDI benefits and fewer costs Free Market View – sees the MNE as an instrument for increasing the overall efficiency of resource utilization in the world economy; no restrictions on FDI

Benefits of FDI to Host Countries Resource-Transfer Effects capital, technology, management Employment Effects direct and indirect creation of jobs by FDI Balance-of-Payments Effect Initial capital inflow to finance FDI; import substitution effects; subsequent exports by the new enterprise Effect on Competition and Economic Growth promotes competition in national markets (i.e. decreases price and increases economic welfare of consumers)

Costs of FDI to Host Countries Adverse Effects on Competition MNEs may monopolize the market Adverse Effects on the Balance-of-Payments outflow of a foreign subsidiary’s earnings; import of inputs from abroad National Sovereignty and Autonomy foreign parent company may make decisions that may hurt the host country

Benefits of FDI to Home Countries Improvement in the balance-of-payments as a result of the inward flow of foreign earnings Positive employment effects when the foreign subsidiary creates demand for home-country exports Reverse resource-transfer effect (i.e. a foreign subsidiary learns valuable skills abroad that can be transferred back to the home country)

Costs of FDI to Home Countries Adverse balance-of-payments effect that arise from the initial capital outflow Export substitution effects of FDI FDI exports jobs abroad

Government Policy Instruments and FDI Home-Country Policies: Encouraging outward FDI (e.g. government-backed insurance programs; government loans; elimination of double taxation of foreign income) Restricting outward FDI (e.g. capital outflow regulations; tax cuts to encourage local operations) Host-Country Policies: Encouraging inward FDI (e.g. tax concessions; low-interest loans; grants or subsidies) Restricting inward FDI (e.g. ownership restraints; performance requirements including local content, technology transfer, local participation in top mgt)