1. Foreign Direct Investment
Discussion Section
February 16, 2007
Brian Chen

2. Agenda Administrative Review Political Economy of FDI
Index cards
Starbucks FDI case due
Word on section participation
Review
Political Economy of FDI
Concepts/Definitions
Application: Chinese Corporations Law relating to wholly foreign-owned enterprises
Foreign Direct Investment
(Time permitting)

3. Review International Trade
“Chicago school” economists tend to favor free trade
But there are political and economic grounds to governments to intervene to check absolute free trade
These tools include:
Tariffs, subsidies, quotas, administrative policies, local content requirement, antidumping policies
Boeing v. Airbus
Both received government subsidies: One direct, one indirect, and the question is whether one form is worse than the other
Also, there may be room to argue whether there are acceptable political and economic grounds for government intervention in these industries

4. Chapter 8
The Political Economy of Foreign Direct Investment

5. Political Economy of FDI: Outline
Three Views
Radical View
“Imperialist” extraction of host country wealth
Implication: Always bad for the host country
Free Market
Different countries have different comparative advantages; best to allow countries to engage activities for which they do so most efficiently
Implication: Always good when countries are specializing in activities for which they have a comparative advantage
Pragmatic Nationalism
Belief that FDI has costs and benefits, and whether to engage in FDI depends on whether the benefits exceed the cost
What are the costs and benefits to the host country?
Benefits
Costs

6. FDI: Benefits to the Host Country
Resource Transfer Effects
Capital
MNE invests capital in foreign markets
Technology
Research supports that MNEs do transfer technology when they invest in a foreign country
Management
When MNEs invest and manage in a foreign country, they often transfer management skills to the host country’s workforce
Employment Effects
MNEs, by investing in foreign countries, can create employment opportunities for the local workforce
But: Acquisition vs. Greenfield Investment
Balance of Payment Effects
Balance of Payment: A country’s balance-of-payment is the difference between the payments to and receipts from other countries
FDI can have beneficial and negative effects on a country’s balance of payment. We look at the beneficial effects next
Effect on Competition
Efficient functioning of markets require adequate level of competition between producers

7. FDI: Benefits to Host Country’s Balance of Payment
Initial Capital Inflow
When a company invests in a foreign country, it brings capital into that country
Substitute for Imports
To the extent that the goods/services produced by the FDI substitute for imported goods/services, there is a positive effect on B-of-P
Inflow of payments from export of goods and services
To the extent that the goods/services produced by the FDI are exported to another country, there is a positive effect on the host country’s B-of-P

8. FDI: Costs to Host Countries
Adverse Effects on Competition
MNEs may have “too much” power and kill off competition
Adverse Effects on Balance of Payments
After initial inflow of capital, subsequent outflow of capital from the earnings of the FDI
FDI may import inputs from abroad
National Sovereignty and Autonomy
Key decisions that affect the host country’s economy may be made by a foreign parent that has no real commitment to the host country

9. FDI: Benefits & Costs to Home Country
Stream of income from foreign earnings
FDI may import intermediate goods or inputs for production from the home country, creating jobs
MNEs may learn skills from exposure to foreign countries
Costs
Balance of payment:
Initial capital outflow (but often set off by future stream of foreign earnings)
Current account suffers if FDI is to serve home market from low-cost production location
Current account suffers if FDI is a substitute for direct export
Employment effects:
FDI a substitute for domestic production (e.g., Etch-A-Sketch)

10. Government Policy Instruments and FDI: Host Country Policies
Encouraging Inward FDI
Tax concessions
Low-interest loans
Grants
Subsidies
Restricting Inward FDI
Ownership restraints
Exclusion from certain industries
Why do so?
To protect national interest (defense, etc)
To facilitate resource-transfer
Performance requirements
Local content, exports, technology transfer, and local participation in top management

11. Government Policy Instruments and FDI: Home Country Policies
Encouraging Outward FDI
Insurance programs to cover major types of foreign investment risks
Special funds or banks to make government loans
Political influence to persuade host countries to relax restrictions on inbound FDI
Restricting Outward FDI
Limit capital outflows
Manipulate tax rules to encourage investment at home
Outright prohibition from investing in certain countries

12. Chinese Law on WOFC
What type of FDI did Starbucks engage in (in Thailand)?
Acquisition? Greenfield?
Horizontal? Vertical?
Wholly owned subsidiary? Joint Venture?
Suppose Starbucks invested in China instead, with the same facts. Does this law apply to your firm?
What are the articles of law that protect the host country?
What are they trying to protect?
What are the article of law that protect the foreign investor?
Why are they important to you?
How would you judge China’s WOFC law?
Does it subscribe to the Radical View, the Free Market View, or the National Pragmatism View?
Why do you say so?

13. Chapter 7
Foreign Direct Investment

14. FDI: Definition What is FDI? Alternatives to FDI
FDI occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country
Examples:
Motorola sets up a plant in China to manufacture cell phones
Starbuck purchases an existing UK firm, “British Coffee,” to sell coffee, tea and desserts in the UK
Volkswagen and two Chinese joint venture partners Shanghai Automotive Industry Corporation (SAIC) and First Automotive Works (FAW) open their newly built gearbox plant in Shanghai "Volkswagen Transmission (Shanghai) Co. Ltd"
Alternatives to FDI
Licensing; Direct Export

15. FDI: Forms Forms of FDI Acquisitions Greenfield Investments Examples:
Purchase an existing company in the foreign country
Greenfield Investments
Set up a new company “from the ground up” in the foreign country
Examples:
Motorola investments money in China and builds a new plant to produce cell phones
Starbucks purchases an existing UK firm “British Coffee” and sells coffee/tea/desserts under the name “Starbucks”

16. FDI: Forms (II) Forms of FDI (II) Wholly Owned Subsidiary
Occurs when the company in the foreign country is entirely controlled/owned by one single company.
Motorola’s company that manufactures cell phones in China
Starbuck’s acquisition that sells coffee/tea/desserts in the UK
Joint Ventures
Occurs when two or more companies together form a new company in the host country
In the international context, usually occurs when one (or more) foreign company and one (or more) local company join to form a new company
Volkswagon + Shanghai Automotive Industry Corporation (SAIC) + First Automotive Works (FAW)

17. FDI: Horizontal vs. Vertical
Horizontal vs. Vertical Direct Investment
Horizontal
Investment in the “same” industry as a firm operates in at home
Examples:
Starbucks and its international expansion
MacDonald’s and its international expansion
Vertical
Investment in a downstream supplier (backward) or upstream purchaser (forward) as compared to the business that the firm operates in its home country
Backward: Volkswagon + SAIC + FAW to produce gearbox (an input to Volkswagon’s home operation)
Forward: Less common. Volkswagon’s acquisitions of dealers in the US (Volkswagon “sold” cars to the dealers in the US. I.e., Volkswagon sold the output of its home country operations to the US dealers that it acquired)

18. Why Horizontal FDI? Transportation Costs Market Imperfections
Impediments to exporting
Impediments to Sale of Know-How
Strategic Behavior
Product Life Cycle
Location Specific Advantages

19. Why Vertical FDI? Strategic Behavior Market Imperfections
Impediments to Know-How
Investment in Specialized Assets