International Business Fourth Edition

The Political Economy of Foreign Direct Investment CHAPTER 7 The Political Economy of Foreign Direct Investment

Chapter Focus This chapter examines the role of government in FDI. Through its actions, governments can encourage or discourage FDI by providing investment incentives or passing laws/implementing policies that restrict foreign investment. Political ideology influences government policy.

Political Ideology and FDI Radical View Free Market Pragmatic Nationalism

Radical View Marxist roots. Influential from 1945 to the 80s. Failure. An instrument of imperialist domination. Exploit host country for the benefit of the MNE. Keeps less developed countries relatively backward and dependent on capitalist nations for investment, jobs, and technology. Influential from 1945 to the 80s. Eastern Europe, China, Cuba, some African countries, Iran, and India. Failure. Collapse of Communism. Poor economic performance. Strong economic performance of countries embracing capitalism.

Free Market View Roots in Smith and Ricardo. International production should be distributed among countries according to the theory of competitive advantage. Positive changes in laws and growth of bilateral agreements attest to strength of free market view. However, all governments, to some degree, intervene in the free market.

Pragmatic Nationalism View FDI as having both benefits and costs. Governments tend toward FDI when benefits versus costs are high. Aggressively court FDI that has national interest ramifications, typically through tax breaks or grants. Technology. Employment. Balance of payment benefits.

Political Ideology Toward FDI Characteristics Host-Government Policy Implications Radical Free Market Pragmatic Nationalism Marxist roots Views the MNE as an instrument of imperialist domination Prohibit FDI Nationalize subsidiaries of foreign-owned MNEs Classical economic roots (Smith) Views the MNE as an instrument for allocating production to most efficient locations No restrictions on FDI Views FDI as having both benefits and costs Restrict FDI where costs outweigh benefits Bargain for greater benefits and fewer costs Aggressively court beneficial FDI by offering incentives Table 7.1

Benefits of FDI to Host Countries Resource-Transfer Effects Management Capital Technology Employment Direct Indirect Balance-of-Payments

US Balance-of-Payments Accounts 2000 $Millions Table 7.2

FDI and Balance-of-Payments Current Account Deficit occurs when imports are greater than exports. Current Account Surplus occurs when exports are greater than imports. Capital Account records transactions that involve the purchase or sale of assets. 3 B-of-P Consequences: When MNE establishes its foreign subsidiary, the host country benefits from initial capital inflow. If the FDI is a substitute for imports, it improves the host country’s balance of payments. Subsidiary is used for exports.

Effect on Competition and Economic Growth FDI can: Increase market competition. Lower prices. Greater consumer choice. Stimulate capital investments. Increase: Productivity. Product/process innovation. Economic growth.

Costs of FDI to Host Countries Adverse Effects on Competition on the Balance of Payments Sovereignty and Autonomy Drive out local competitors Earnings & imports hurt capital account Key economic decisions made by ‘foreigners’

Benefits and Costs of FDI to Home Countries Inward flow of earnings Creates export demand Increased knowledge Balance of Payments hurt Potential reduction in home country employment Initial capital outflow Sells back to home market Substitute for exports

International Trade Theory and FDI Home-country concerns about offshore production may be misplaced. Offshore production refers to FDI undertaken to serve the home market. May increase employment by freeing home country resources to concentrate on activities where the home country has a competitive advantage. May lead to lower prices for consumers.

Government Policy Instruments and FDI Home Country Policies Encourage Outward FDI Government backed risk insurance. Government loans. Eliminate double taxation. Political persuasion to relax restrictions on inbound FDI. Restricting Outward FDI Limit capital outflows. Use tax code to encourage companies to stay home. Prohibitions against investing in certain countries (Cuba, Libya, Iran).

Government Policy Instruments and FDI Host Country Policies Encourage Inward FDI Offer investment incentives. Tax concessions. Low-interest loans. Grant/subsidies. Attempt to attract investment away from other countries. Restricting Inward FDI Ownership restraints. Excluded from specific fields. National security. Competition. Restrictions on amount of ownership. Performance requirements. Local content. Technology transfer. Local participation in management

International Institutions and the Liberalization of FDI WTO OECD Developed nations have had problems agreeing on rules. Developing nations have been reluctant to agree to liberalization.

The Context of Negotiation The four Cs Common Interests Negotiation Process Conflicting Interests Criteria Compromise Compromise Figure 7.1

Determinants of Bargaining Power Bargaining Power of Firm High Low Long Short Low Many Few High Firms time horizon Comparable alternatives open to firm Value placed by host government on investment Table 7.3