The benefits and costs of FDI ***POLITICAL ECONOMY*** THE POLITICAL ECONOMY OF FDI Some people and/or countries regard FDI, or more generally, multinational enterprises (MNEs) as a tool of imperialism (a radical view).   However, most have more pragmatic views on MNEs The benefits and costs of FDI (A) to host countries: 1. Benefits 2. Costs 3. Unclear Example. Balance of payments???  Example. Environment?

Recall: the impact of inward FDI on the host country’s balance of payments: Construction, FDI’s exporting, $ from abroad (?) FDI’s dividends, consulting fees, etc (?)   (B) to home countries: 1. Benefits: efficient allocation of resources 2. Costs 3. Uncertain    Example. Balance of payments (same as above) Example. Environment? Implications for IB: Where should you build your overseas factory?

Your negotiation with the host country government for FDI may be needed Relatively little problem exists for most developed countries. But some (like Canada) do have foreign investment review mechanisms, particularly, for certain industries (why?)   -Developing countries usually have some forms of restrictions on FDI (why?) -Important to recognize what gives you and the host government the bargaining power (we’ll discuss this shortly) - The higher your bargaining power is relative to the bargaining power of the host government, the more of what you want you will get in your FDI

The Bargaining Power and FDI POLITICAL ECONOMY OF FDI (Con’d): The Bargaining Power and FDI The outcomes of the negotiation between you (MNEs) and the host government (h.g.) about your FDI in developing countries reflected in:   (1) tax, foreign exchange and other financial concessions by the h.g.; (2) legal arrangements; (3) the rights to name board members; and (4) local (or your) ownership share in your FDI (subsidiary). (Related to (3).) 4

Example. Tax issue involving Amazon.com and political economy The Japan-U.S. bilateral tax treaty allows U.S. firms to operate in Japan without paying Japanese taxes under the following conditions: “U.S. companies that engage in business in Japan without "permanent establishment" such as branch offices from having to file a tax return or pay taxes in Japan.” Because Japan’s corporate income tax rate is higher than US.’s, U.S. firms have every incentive to use this form of FDI where possible. Amazon.com is one of them. Their business in Japan has been highly successful and profitable. They keep their inventories in a number of large warehouses in Japan, from which their subsidiaries operate logistics for Amazon International. Japanese tax authorities decided that this form of Amazon.com’s operation in Japan is a branch office operation and collected from them US$119 million as back taxes plus penalty.

The Tokyo Regional Taxation Bureau has determined that Amazon The Tokyo Regional Taxation Bureau has determined that Amazon.com’s two Japanese wholly owned subsidiaries have in effect acted as branch offices of the affiliate, Amazon.com International Sales Inc. (The two subsidiaries, Amazon Japan Logistics K.K. and Amazon Japan K.K., are commissioned to carry out merchandise distribution and other functions. Amazon.com International Sales concluded direct contracts with its customers in Japan and received payments for goods, the sources said.) The tax bureau reportedly told Amazon.com International Sales that it should have declared to Japanese tax authorities a substantial amount of the income gained through transactions in Japan. Amazon.com disclosed in its annual report for the 2008 business year that it has been ordered by Japanese tax authorities to pay US$119 million as the back taxes plus penalty for an amount equivalent to ¥14 billion. Amazon.com International Sales is responsible for operations outside the United States. The company has booked sales posted in Japan as those of the Seattle-based company while paying relevant taxes only in the U.S. But the tax bureau found that employees of Amazon Japan Logistics have received instructions from the U.S. side through e-mails at its distribution center in Ichikawa, Chiba Prefecture, while approval by the U.S. side was required whenever the center's administrators assigned its employees to new posts, the sources said, indicating it acted as a branch. Amazon filed objections about this judgment, and Japanese and U.S. governments are negotiating this issue. However, other countries where Amazon operates in a similar way may follow Japan’s suit.

Local (and hence your) ownership share in the foreign operation The most important outcome of the negotiation between the host government and you is:   Local (and hence your) ownership share in the foreign operation you own 100 %, local share 0% 80%, local share (who?) 20% 50%, local share (who?) 50% 20%, local share (who?) 80% .....………………………........................................... Many governments in developing countries consider local ownership as an important goal when they negotiate with foreign investors. The ownership issue also arises sometimes in developed countries. This may be due to their political motivations; investment regulations emphasize joint venture requirements; worries about foreign control of key industries, etc. WHY? Example. Canadian limits on foreign ownership in airlines: 33%; telephone operators (AT&T Canada-33%); ..... 7

What are the sources of bargaining power ? Many (but not all) MNEs also view ownership share in FDI very important   Examples. -Why did IBM and Coca-Cola insist on fully owned subsidiaries for their key FDI operations in India? -Recently, Russia required Shell and other MNEs to give up their owenership in JVs to explore oil and gas in Sakhalin Island; Kazafstan also reduced MNEs’ ownership in their JVs in the oil industry. Many governments (and also MNEs) are unwilling to trade ownership for other kinds of benefits (particularly in resource sectors). Your share and local share in your FDI are determined by your relative bargaining power vis-a-vis the host government’s bargaining power. What are the sources of bargaining power ? Your ownership in an FDI operation in a developing country often determined by negotiation with the host government Such negotiations may also be necessary for FDI in sensitive industries in developed countries (e.g. resources, defence, regulated industries,…) 8

Sources of your bargaining power Your bargaining power is higher if you can offer what the other party (the host government) wants. Of course, higher bargaining power --- > less trouble on FDI (e.g. confiscation)   Sources of your bargaining power 1. Technology: U.S. operations in Latin America: R&D / sales (%) %ownership 0 -. 75 88% .75 - 2.5 86 2.5 - 5.0 89 5% + 99 9

2. Product differentiation (p.d.) Examples. Food, beverages, ball-point pens,.. Generally low-tech products. Heavy multinational advertisers do not usually want to share marketing policy U.S. operations in Latin America   Adv / sales (%) %ownership 0 - 1 % 85 1 - 7 89 7% + 98 10

%output transferred %ownership within the parent system 0 - 10 % 80 3. Market access %output transferred %ownership within the parent system   0 - 10 % 80 10- 50 91 59- 100 96 %exported 0 - 10 88 10- 50 92 50- 100 98 Note: control over market access is a particularly effective deterrent to expropriation 11

4. Competition weakens your bargaining power # of parent firms competing in 3-digit SIC industry %ownership   1 95 2 90 3-5 84 6 + 83 Depending on the industry and the host government environment, one or more of these factors provide bargaining power in your negotiation with the host government and/or local partners. 12

Alternative Dissolution of Joint Ventures (A power game between the JV parents)

Additional examples: alternative dissolution of M&A and strategic alliances Daimler and Chrysler (Daimler acquired Chrysler in a friendly M&A. Later split.) Suspected reason: differences in country-specific and corporate culture . Fiat now owns Chrysler. Daimler and Mitsubishi Motor Corporation (Daimler acquired controlling share / ownership of MMC (friendly M&A). Later Daimler sold back passenger car business to MMC. Daimler still controls the former truck division of MMC (Mitsubishi Fuso brand).) Suspected reason: MMC’s non-disclosure of certain corporate information (related to recallable car defects) in M&A negotiations. VW and Suzuki Motor Corporation (In a friendly agreement, VW acquired 19.9% of Suzuki shares and Suzuki also acquired a small piece of VW, to exchange technology related to environmentally friendly car designs, etc. Suzuki went ahead with procuring diesel engines from Fiat without any consulting with VW, infuriating VW. Suzuki and Fiat had prior business relationships. Suzuki argues their relationship with VW to be an equal one, blaming VW’s increasing interference with Suzuki’s management. Suzuki asked VW to sell back their Suzuki shares to Suzuki immediately, and VW refused. The saga goes on.