1. Session Investment Theory

2. Topic Outline Foreign Direct Investment Trade Deficit Ownership Location Internalisation Balance of Payment

3. This Session Weekly Activity: Economic Integration Consider this question: Why is regional economic integration important to international companies? What are the implications for managers in MNE’s? How important is it for free trade zones to have a common market, currency and language? Is this necessary for long term prosperity? Look at the pro’s and con’s when thinking about your response. Word Count: 200 - 300

4. The New World Economy The world economy has become increasingly interconnected: Globalization: markets exceed national boundaries; increased mobility of workers, products, and information. Integration: people of different countries choose to function jointly in governance, economic interests, currency, etc.

5. Developments The possibility of such a global economy has been brought about by: Collapse of communism Lower transportation costs Advances in telecommunications (internet, etc.) related technological innovations Economic need These have led to reductions in trade barriers General barriers Integration and free trade zones—Europe, North America, etc. The relaxation of bank and capital market regulations

6. The movement of capital has allowed foreign direct investments across the globe International Investment Theory

7. Foreign Direct Investment (FDI) Any flow of lending to, or purchases of ownership in, a foreign enterprise that is largely owned by residents of the investing country. Securities (stocks and bonds) Loans Bank deposits Minority ownership positions FDI is the purchase of assets to establish financial control of a foreign entity. Generally ownership of 10% or more of a company’s outstanding stock is considered FDI. Portfolio investment involves little management control or interest, and is solely for financial gain.

8. Topic Example Video The following video is a discussion on FDI in the retail sector in India. Take note of the key points http://www.youtube.com/watch?v=CXY31bf_57g

9. International Investment Types Portfolio investments represent passive holdings of securities such as foreign stocks, bonds, or other financial assets, none of which entail active management or control of the securities’ issuer by the investor. Foreign direct investment (FDI) acquisition of foreign assets for the purpose of controlling them. U.S. government statisticians define FDI as “ownership or control of 10 percent or more of an enterprise’s voting securities…or the equivalent interest in an unincorporated U.S. business.

10. Dunning’s Eclectic Theory This theory recognizes that FDI reflects both international business activity and business activity internal to the firm. According to Dunning, FDI will occur when three conditions are met: Ownership advantage Location advantage Internalization advantage

11. Ownership Advantage Theory The ownership advantage theory suggests that a firm owning a valuable asset that creates a competitive advantage domestically can use that advantage to penetrate foreign markets through FDI. Why FDI and not other methods?

12. O = Ownership advantages Some firms have a firm specific capital known as knowledge capital: Human capital (managers), patents, technologies, brand, reputation… This capital can be replicated in different countries without losing its value, and easily transferred within the firm without high transaction costs

13. L – Localization advantages Producing close to final consumers or downstream customers Saving transport costs Obtaining cheap inputs Jumping trade barriers Provide services (for most services production and delivery have to be contemporaneous)

14. I – internalization advantages Why don't a firm just sign a contract with a subcontractor (external agent) in a foreign country? Because contracting out is risky: it implies transferring the specific capital outside the firm and revealing the proprietary information (e.g. how to use the technology or the patent). Problem: If the agent interrupts the contract it can use the technology to compete with the mother company In the case of brands/reputation: if the agent damages the brand reputation

15. Internalization Theory Transaction costs are the costs of entering into a transaction; that is, those connected to negotiating, monitoring, and enforcing a contract. Internalization theory suggests that FDI is more likely to occur—that is, international production will be internalized within the firm—when the costs of negotiating, monitoring, and enforcing a contract with a second firm are high.

16. Internalization Theory FDI is more likely to occur when transaction costs with a second firm are high. Transaction costs are costs associated with negotiating, monitoring, and enforcing a contract.

17. OLI approach - conclusions The eclectic, or OLI paradigm, suggests that the greater the O and I advantages possessed by firms and the more the L advantages of creating, acquiring (or augmenting) and exploiting these advantages from a location outside its home country, the more FDI will be undertaken Where firms possess substantial O and I advantages but the L advantages favor the home country, then domestic investment will be preferred to FDI and foreign markets will be supplies by exports

18. 4 types of FDI derived from OLI theory The typology of FDI was developed by Jere Behrman to explain the different objectives of FDI: Resource seeking FDI Market seeking FDI Efficiency seeking (global sourcing FDI) Strategic asset/capabilities seeking FDI

19. Firms as Seekers Seeking Resources Seeking Factor Advantages Seeking Knowledge Seeking Security Seeking Markets International Investment Theory

20. Resource seeking FDI To seek and secure natural resources e.g. minerals, raw materials, or lower labor costs for the investing company For example, a German company opening a plant in Slovakia to produce and re-export to Germany

21. Market seeking FDI To identify and exploit new markets for the firms` finished products Unique possibility for some type of services for which production and distribution have to be contemporaneous (telecom, water supply, energy supply) Automotive TNCs have invested heavily in China

22. Efficiency seeking FDI To restructure its existing investments so as to achieve an efficient allocation of international economic activity of the firms International specialization whereby firms seek to benefit from differences in product and factor prices and to diversify risk Global sourcing – resource saving and improved efficiency by rationalizing the structure of their global activities. Undertaken primarily by network based MNCs with global sourcing operations.

23. Strategic asset/capabilities seeking FDI MNCs pursue strategic operations through the purchase of existing firms and/or assets in order to protect O specific advantages in order to sustain or advance its global competitive position Acquisition of key established local firms Acquisition of local capabilities including R&D, knowledge and human capital Acquisition of market knowledge Pre empting market entrance by competitors Pre empting the acquisition by local firms by competitors

24. International Investment Theory Firms as Exploiters of Imperfections Imperfections in Access Imperfections in Factor Mobility Imperfections in Management Firms as Internalizers Establish their own multinational operations- internalize production Competitive advantage due to confidentiality

25. FDI Decision Factors Supply Factors Demand Factors Political Factors

26. Supply FactorsDemand FactorsPolitical Factors Production costsCustomer accessAvoidance of trade barriers LogisticsMarketing advantagesEconomic development incentives Resource availabilityExploitation of competitive advantages Access to technologyCustomer mobility FDI Decision Factors

27. Where to Invest? The decision to invest abroad is often a stage in the firm’s development process. Eventually the firm experiences a stimulus from the external environment, which leads it to consider production abroad. Some important external stimuli are: An outside proposal, from a quality source Fear of losing a market The “bandwagon” effect Strong competition from abroad in the home market

28. Modes of Foreign Involvement The globalization process includes a sequence of decisions regarding where production is to occur, who is to own or control intellectual property, and who is to own the actual production facilities. The following exhibit provides a roadmap to explain this FDI sequence.

29. The FDI Sequence: Foreign Presence & Foreign Investment The Firm and its Competitive Advantage Exploit Existing Competitive Advantage Abroad Change Competitive Advantage Licensing Management Contract Control Assets Abroad Acquisition of a Foreign Enterprise Greenfield Investment Production at Home: Exporting Production Abroad Joint Venture Wholly-Owned Affiliate Greater Foreign Presence Greater Foreign Investment

30. Modes of Foreign Investment Exporting versus production abroad: There are several advantages to limiting a firm’s activities to exports as it has none of the unique risks facing FDI, Joint Ventures, strategic alliances and licensing with minimal political risks The amount of front-end investment is typically lower than other modes of foreign involvement Some disadvantages include the risks of losing markets to imitators and global competitors

31. Modes of Foreign Investment Licensing and management contracts versus control of assets abroad: Licensing is a popular method for domestic firms to profit from foreign markets without the need to commit sizeable funds However, there are disadvantages which include: License fees are lower than FDI profits Possible loss of quality control Establishment of a potential competitor in third-country markets Risk that technology will be stolen

32. Modes of Foreign Investment Management contracts are similar to licensing, insofar as they provide for some cash flow from a foreign source without significant foreign investment or exposure Management contracts probably lessen political risk because the repatriation of managers is easy

33. Modes of Foreign Investment Joint venture versus wholly owned subsidiary: A joint venture is here defined as shared ownership in a foreign business Some advantages of a MNE working with a local joint venture partner are: Better understanding of local customs, mores and institutions of government Providing for capable mid-level management Some countries do not allow 100% foreign ownership Local partners have their own contacts and reputation which aids in business

34. Modes of Foreign Investment However, joint ventures are not as common as 100%-owned foreign subsidiaries as a result of potential conflicts or difficulties including: Increased political risk if the wrong partner is chosen Divergent views about the need for cash dividends, or the best source of funds for growth (new financing versus internally generated funds) Transfer pricing issues Difficulties in the ability to rationalize production on a worldwide basis

35. Modes of Foreign Investment Greenfield investment versus acquisition: A greenfield investment is defined as establishing a production or service facility starting from the ground up Compared to a greenfield investment, a cross- border acquisition is clearly much quicker and can also be a cost effective way to obtain technology and/or brand names Cross-border acquisitions are however, not without pitfalls, as firms often pay too high a price or utilize expensive financing to complete a transaction

36. Modes of Foreign Investment The term strategic alliance conveys different meanings to different observers. In one form of cross-border strategic alliance, two firms exchange a share of ownership with one another. A more comprehensive strategic alliance, partners exchange a share of ownership in addition to creating a separate joint venture to develop and manufacture a product or service Another level of cooperation might include joint marketing and servicing agreements in which each partner represents the other in certain markets.

37. Direct Investment Concerns How much shall the country control the direct investments? What can foreigners buy? Land, real estate sale to foreigners limited (Eastern Europe) Certain stock can not be purchased (China, Russia) How shall profit be distributed? Profit drain? Many foreign firms in US reinvest most of their profits.

38. Ikea aggressively exports its furniture to other countries Foreign Direct Investment Example

40. Balance of Payments A record of international transactions between residents of one country and the rest of the world International transactions include exchanges of goods, services or assets “Residents” means businesses, individuals and government agencies, including citizens temporarily living abroad but excluding local subsidiaries of foreign corporations

41. Topic Example Video The following video explains what is meant by Balance of Payments. Take note of the key points http://www.youtube.com/watch?v=UCI3uaExEM4

42. BOP Accounting Monetary and fiscal policy must take the BOP into account at the national level BOP data may be important Indicates pressure on exchange rate May signal imposition/ removal of controls over payments, dividends, interest. Helps forecast country’s market potential BOP is a flow statement, not a stock statement. Main transactions in BOP: Exchange of real assets. Exchange of financial assets.

43. Business Transactions Economists typically separate the production and sale of goods and services from the exchanges of financial assets. Real Sector: production and sale of goods and services. Financial Sector: transactions in global, foreign, or domestic financial assets. Measurement is difficult because trade may include services (invisibles) and electronic commerce.

44. BOP Accounting How to measure international economic activity? Is it an international economic transaction? How do flow of goods/services/assets/money translate in credits & debits? Bookkeeping procedures for BOP? Mistakes are common…

45. BOP Double-entry Accounting All transactions are either debit or credit transactions Credit transactions result in receipt of payment from foreigners Merchandise exports (valued f.o.b.) Transportation and travel receipts Income received from investments abroad Gifts received from foreign residents Aid received from foreign governments

46. Double-entry Accounting (Cont’d) Debit transactions involve to payments to foreigners Merchandise imports Transportation and travel expenditures Income paid on investments of foreigners Gifts to foreign residents Aid given by home government Overseas investments by home country residents Each credit transaction has a balancing debit transaction, and vice versa, so the overall balance of payments is always in balance.

47. Balance of Payments BOP includes two main components:  Current Account  Capital Account The Current Account and Capital Account always balance each other out. The reason for this harmonic state of affairs will become clear shortly.

48. Accounts Overview (Level 1) Current Account (all real transfers) Merchandise trade Service trade Transfers Capital and Financial Account (transfers of ownership and financial assets and liabilities) Changes in private assets Changes in holdings of official international reserves Statistical Discrepancy

49. Topic Example Video The following video explains what is a Current Account Balance. Take note of the key points http://www.youtube.com/watch?v=Pbj9auFz9Ck

50. Current Account Record of daily trade of goods and services between a nation and the rest of the world. Split into two pieces:  Merchandise trade (or Visible) account – records trade in goods  Invisible account – records trade in services Current Account includes investment income flows (interest and dividends), private transfers and direct foreign aid, in addition to “pure” goods and services.

51. What is Investment Income? Payment to holders of foreign financial assets, including: Interest on bonds and loans Dividends and other claims on profits by owners of foreign businesses Payments made to temporary (nonresident) workers

52. Current Account The current account is that balance of payments account in which all short-term flows of payments are listed: Goods and services balance (exports – imports) Merchandise trade balance (exports – imports) Services balance (exports – imports) Net Investment income Unilateral transfers Private transfer payments Governmental transfers

53. What are Services? Travel and tourism Trade transportation Insurance Education Financial, technical, and marketing services Telecommunication Use of property rights (royalties) Other professional and consulting services

54. Unilateral Transfers Official government grants in aid to foreign governments Charitable giving (e.g., famine relief) Migrant workers transfers to families in their home countries

55. Current Account The net exports (exports minus imports) of goods and services for a country is its trade balance. If a country has positive net exports of goods and services (more exports than imports), it has a trade surplus. Negative net exports of goods and services means the country is running a trade deficit.

56. Capital Account The capital and financial account is that balance of payments account in which all cross-border transactions involving financial assets are listed. This includes transactions between foreign and domestic residents, and foreign and domestic governments. All purchases or sales of assets, including: Direct investment Securities (debt) Bank claims and liabilities Official reserves transactions When U.S. citizens buy foreign securities or when foreigners buy U.S. securities, they are listed here as outflows and inflows, respectively.

57. Capital Account Records the difference between the purchase of foreign assets by domestic residents and the purchase of domestic assets by foreigners. Includes direct purchases of hard assets (land or mineral rights, production facilities, etc.) and financial assets (stocks, bonds, bank deposits). The net change in the Capital Account is a country’s net capital outflow (or net foreign investment).

58. The Capital/Financial Account Capital account: transfers of fixed assets, real estate, acquisitions/disposal of non-produced/non-financial assets Financial account: three components; classified by degree of control, Direct Investment – Net balance of capital which is dispersed from and into a country for the purpose of exerting control over assets. E.g. Domestic company acquires foreign company stake (-) Foreign company acquires Domestic company stake (+) foreign direct investment (FDI): 10%+ of voting shares acquired.

59. The Capital/Financial Account Portfolio Investment – Net balance of capital which flows in/out of a country but does not reach 10% ownership. No voting or control rights over the asset. Purchase/sale of equity securities. Purchase/sale of debt securities. E.g. Trade purchases by foreigners (net portfolio investment) E.g. Bond$ debt issues by foreign companies/ governments. Risk/Return motivated. Far more volatile than FDI. Other Investment Assets/Liabilities –Short & long- term trade credits, cross-border loans, currency & bank deposits, & other accounts receivable and payable in cross-border trade.

60. Current & Financial/Capital Account Balances, US, 1992 - 1999 (US$ bn) Source: International Monetary Fund, Balance of Payments Statistics Yearbook, 2000.

61. Are Trade Deficits Bad? It depends … First, all countries cannot have a trade surplus (positive Current Account balance). All open economies are part of the same global economic system – one country’s surplus must eventually be balanced by another country’s deficit.

62. Topic Example Video The following video is a discussion on why Germany is doing fine post GFC. Take note of the key points http://www.youtube.com/watch?v=O1Qpk2RgcBg

63. Trade Deficits (Cont’d) Would a country normally prefer to be a net exporter (run a trade surplus)? Perhaps, but like an individual who takes on personal debt, whether or not they are better off in the long run depends on how they got into debt and what they do with the money. Which is why a discussion of trade deficits inevitably leads to an analysis of the underlying causes – and often a debate about trade policy.

64. Activity: Australian Trade Deficit Go to: www.ato.gov.au and www.ato.gov.au Analyze the flow of goods and services underlying the current Australian trade deficit. What do you think? Is it sustainable? Is it dangerous (or healthy)? Are we in trouble? Word Count: 200 - 300

65. Next Session Weekly Activity: Investment Position Manual Consider this: The International Monetary Fund (IMF) have implemented new standards for Financial Reporting in the Euro Zone. These include: Timely quarterly statistics National accounts consistency Investment position relevance Financial intermediaries Investment fund shares Listed / non-listed equity Download the manual at: www.imf.org Comment on the standards.