Welcome to Global Business Today, Seventh Edition by Charles W.L. Hill.
Chapter 7: Foreign Direct Investment
If you’ve traveled to London or Beijing, you may have seen some familiar companies like Starbucks or McDonald’s as you walked through the streets. These companies have investments in many countries around the world. In fact, as you’ll recall from the Opening Case, Wal-Mart recently continued its international expansion by acquiring a stake in Japan’s Seiyu. Even if you haven’t traveled to other countries you can see examples of foreign direct investment in your own country. For example, Nissan and Toyota have both made investments in the U.S., and Ford has factories in Mexico. Foreign direct investment, or FDI, occurs when a firm invests directly in new facilities to produce and/or market in a foreign country. Once a firm undertakes FDI it becomes a multinational enterprise or MNE. There are two main forms of FDI. A greenfield investment involves establishing a wholly owned new operation in a foreign country. This is what Starbucks has done for most of its foreign expansion. The second type of FDI is an acquisition or merger with an existing firm in the foreign country. Wal-Mart chose this path with its acquisition of Seiyu.
You probably already know that companies are expanding in foreign countries more than ever. But, let’s look at the patterns of FDI in the world economy a little more closely. Before we do that though, we need to go over a few definitions. The flow of FDI refers to the amount of FDI undertaken over a given period of time. The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. Outflows of FDI are the flows of FDI out of a country, while inflows of FDI are the flows of FDI into a country.
What trends in FDI can we see over the last twenty years or so? Well, there has been a marked increase in both the flow and stock of FDI in the world economy. In 1975, the outflow of FDI was about $25 billion, by 2000, it was $1.2 trillion. It dropped back a bit in 2005 to $897 billion, but as you can see, there is a clear upward pattern. Why has there been such a significant increase in FDI outflows? There are several reasons for this pattern. Firms are worried about protectionist measures, and see FDI as a way of getting around trade barriers. Second, changes in the economic and political policies of many countries have opened new markets to investment. Think, for example of the changes in Eastern Europe that have made it possible for foreign firms to expand there. Third, many firms see the world as their market now, and so are expanding wherever they feel it makes sense. Wal-Mart for example, sees growth opportunities in foreign markets that may not be available in the U.S. Many manufacturers are expanding into foreign countries to take advantage of lower cost labor, or to be closer to customers, and so on.
As you can see from Figure 7.1, there is a clear upward trend in the pattern of FDI from 1982 to 2009.
Where is the investment going? Which countries are the recipients of the investment flows? Historically, most FDI has been targeted toward developed countries, with the U.S. being a favorite target during the 1980s and 1990s. The U.S. is attractive because it’s large and wealthy, it’s politically stable, and it’s open to investment. The European Union countries share some of these same characteristics and have also been favorite targets for investment. We’re also seeing an increase in investment in developing nations like the emerging economies of South, East, and Southeast Asia. China, for example, attracted $60 billion in FDI in 2004 and nearly $108 billion in 2208! You can learn more about China’s new role in the global economy in the Country Focus in your text. Latin American is also emerging as an important destination for FDI. The region attracted more than $144 billion in investments in 2008.
As you can see, over the last decade or so, the flows of FDI have a distinct upward trend in both developed and developing countries.
We can also look at FDI flows in terms of percentages of gross fixed capital formation, or the total amount of capital invested in factories, stores, office buildings, and so on. All else being equal, the greater the capital investment in an economy, the more favorable its future prospects are likely to be. In other words, FDI can be an important source of capital investment which can be factor in the future growth rate of an economy.
Where has all the FDI been coming from? Since, World War II, the U.S. has been the largest source country for FDI. Other important source countries include the United Kingdom, the Netherlands, France, Germany, and Japan. Together, the six countries accounted for about 56 percent of all FDI outflows from 1998 to 2008!
Here you can see the cumulative FDI outflows from 1998 to 2008. Notice the dominance of the United States, the United Kingdom, and France.
You may be wondering how most firms make their investments. Do they establish greenfield operations, or do they merge or acquire existing firms? Most firms make their investments either through mergers with existing firms, or acquisitions. Firms prefer this route because mergers and acquisitions tend to be quicker to execute than greenfield investments, it’s usually easier to acquire assets than build them from the ground up, and because firms believe they can increase the efficiency of acquired assets by transferring capital, technology, or management skills. Keep in mind that when a developing country is the target for FDI flows, mergers and acquisitions are much less common, probably because there are fewer firms to acquire or merge with in developing countries.
So, why do firms make investments in other countries? Why don’t firms just export or sign a licensing agreement with a foreign company if they want to sell their products in other markets? We’ve alluded to some of the reasons already, but let’s explore some of the theories that help us understand FDI. We’ll begin with looking more closely at some of the limitations of exporting and licensing.
Remember that exporting involves producing goods at home and then shipping to the receiving country for sale. While this may seem to be an obvious way to expand into foreign markets, it’s not always possible. Imagine trying to export cement for example! Even smaller things like soft drinks can be expensive to ship over long distances. Even if products are easy to ship like computer software, firms may run into trade barriers that make this strategy less attractive. Japanese auto producers for example, found that it was easier to set up shop in the U.S. than to deal with the protectionist threats made by the U.S. government in the 1980s and 1990s.
Now, let’s look at why licensing isn’t always a viable option for foreign expansion. Recall that licensing involves granting a foreign entity the right to produce and sell the firm’s product in return for a royalty fee on every unit the foreign entity sells, and while it may seem like a good way to get into a foreign market without the costs and risks of FDI, like exporting, licensing isn’t always attractive to companies. Internalization theory suggests that licensing isn’t appropriate for three main reasons. First, licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitor. RCA found this out the hard way. RCA licensed its cutting edge color TV technology to Sony and Matsushita in the 1960s only to find that they copied the technology and used it to compete against RCA in the U.S. market. So, instead of expanding successfully into Japan, RCA became a minor player in its own market! A second problem with licensing is that it doesn’t give a firm the tight control over manufacturing, marketing, and strategy that may be required to be successful in a foreign market. So, the firm doesn’t have the ability to set prices, or market aggressively, and so on. Instead, it’s at the mercy of the licensee. Finally, if a firm’s competitive advantage is based on management, marketing, or manufacturing capabilities rather than its product, licensing is probably not attractive. Much of Toyota’s competitive advantage for example, lies in its superior process of designing, engineering, manufacturing, and selling cars. Toyota can’t just license that know-how out to another firm because the skills are embedded in its organizational culture! This efficiency is critical to Toyota’s success. In 2005, for example, the company was able to earn about $2,400 more per car than the Big Three American automakers.
So, again firms will prefer FDI to exporting or licensing when transportation or trade barriers make exports unattractive, and when it wants to maintain control over its technological know-how, over its operations and business strategy, or when its capabilities are simply not amenable to licensing.
One interesting pattern we see with FDI is that firms in the same industry often make investments at about the same time, and tend to direct their investments toward certain locations. Recall for example, when the three major Japanese auto companies all shifted production to the U.S. Why do we see these types of patterns? There are two theories that can help us understand the pattern. Let’s look at each one.
One theory to explain these patterns is based on the idea that FDI flows reflect strategic rivalry between firms. Knickerbocker explored the relationship between FDI and rivalry in oligopolistic industries, or industries that are composed of a limited number of large firms. These industries are unique because what one company does can have an immediate effect on the other firms, forcing them to take similar actions. Take the airline industry for example. If one airline cuts prices on certain routes, you see other airlines quickly make similar changes. In an international context, recall that after Honda made its successful investment in the U.S., Toyota and Nissan both followed. Knickerbocker’s theory can also be used to embrace the idea of multipoint competition which occurs when two or more companies encounter each other in different markets. Firms will try to match each others’ moves as a way of keeping each other in check. Kodak and Fuji play this game. If Kodak enters a market, so will Fuji. By doing so, Fuji can make sure that Kodak doesn’t gain a dominant position in the market that it could then use to gain advantage elsewhere. What Knockerbocker didn’t explain though, was why the first firm in an oligopoly decided to invest rather than export.
You might remember Vernon’s product life cycle that we discussed in Chapter 5 which suggested that firms will change their strategy as a product moves through its life cycle. One component of his theory was that firms would invest in other developed countries when local demand justified local production, and that later when the product was standardized and sold mainly on price, production would shift to a lesser developed location to take advantage of low cost labor. Like Knickerbocker, Vernon explained why investment took place, but not why investment was preferable to exporting. Why, for example, should a firm produce in another country just because demand has grown? Why not continue to export, or perhaps license a local firm to produce the product?
John Dunning tried to fill in these gaps in our understanding with his eclectic theory. Dunning suggested that in addition to the various factors we’ve already discussed, there must be location specific factors and externalities that make FDI preferable. Location specific advantages refer to the advantages that come from using resources or assets that are tied to a specific location or that a firm finds valuable to combine with its own unique assets. Externalities are knowledge spill-overs that occur when companies from the same industry locate in the same area. So, firms that want to take advantage of low cost labor, have to go to where the low cost labor is located. Firms that want to take advantage of natural resources like oil have to go to where the oil is located. Firms that want to take advantage of the knowledge base in the design and manufacture of computers and semiconductors have to go to Silicon Valley. So, Dunning’s theory is important because it explains how location specific factors affect FDI flows.
Now that you’re familiar with some of the theories that explain FDI, as well as the patterns of FDI we see in the global economy today, let’s explore how a government’s attitude affects FDI. You can think of ideology toward FDI as being on a continuum where at one end is the radical view that’s hostile to all FDI, and at the other end is the noninterventionist principle of free market economies. In between these two extremes is pragmatic nationalism.
Let’s start with the radical view, which as you might guess, traces its roots to Marxist political and economic theory. This perspective argues that the MNE is an instrument of imperialist domination and a means of exploiting host countries for the benefit of their capitalist-imperialist home countries. In other words, people taking this perspective believe that the MNE will fill all important jobs with home country citizens, and so control key technology leaving the host nation dependent on the capitalist country for investment, jobs, and technology. This perspective was very influential in the world from about 1945 until the 1980s and the collapse of communism. Since, then the radical stance has been in retreat as people see that the countries that embraced capitalism rather than the radical ideology have been far more successful economically.
At the other end of the continuum remember, is the free market perspective which argues that international production should be distributed among countries according to the theory of comparative advantage. So, of course it traces its roots to Adam Smith and David Ricardo. This perspective suggests that countries specialize in the production of the goods they can produce most efficiently and trade for everything else. It then follows, that FDI will actually increase the overall efficiency of the global economy. So, if Ford moves the assembly of some of its cars to Mexico to take advantage of cheaper labor costs, Ford is not only freeing up resources in the U.S. which could then be used in activities in which the U.S. has a comparative advantage, Ford’s also transferring technology, skills, and capital to Mexico. Both countries gain! While no country has adopted the pure free market stance, this ideology has been embraced by many developed and developing nations like the U.S., Hong Kong, and Chile.
In the middle of the continuum is pragmatic nationalism which argues that FDI has both benefits and costs. Benefits include things like inflows of capital, technology, skills, and jobs, while costs include the repatriation of profits and negative balance of payments effects. Pragmatic nationalism suggests that FDI should only be allowed if the benefits outweigh the costs.
We’ve seen a shift toward the free market stance in recent years, and you already know of course that along with that shift there’s been a surge in FDI. Keep in mind though, that FDI is still viewed with hostility in some countries and in some situations. As the Management Focus in your text outlines, the U.S. recently rejected an effort by DP World to invest in U.S. ports.
Let’s explore some of the costs and benefits of FDI that could affect whether an investment is given approval. Keep in mind that we need to consider costs and benefits from the home country’s perspective and the hosts country’s point of view.
The main benefits for a host country of inward FDI are resource transfer effects, employment effects, balance of payments effects, and effects on competition and economic growth. Let’s look at each one.
We’ve actually already talked a bit about the first benefit—resource transfer effects. Remember that FDI can benefit a country by bringing in capital, technology, and management skills helping the country to increase its economic growth. Similarly, FDI can mean jobs! Many people in Middle Tennessee for example are employed at Nissan facilities there, and because the Nissan workers need houses to live in, grocery stores, and schools. A host of other related jobs have been created as well. Keep in mind of course, that some of these jobs will be canceled out by the loss of jobs in Detroit that will occur when U.S. consumers buy Nissans instead of Fords!
FDI also has an effect on a country’s balance of payments. You’ve probably heard of the balance of payments, it’s a record of a country’s payments to and receipts from, other countries. The current account keeps track of a country’s export and import of goods and services. This is the account you often hear about in the news when you hear of the country’s trade deficit with China for example. Governments prefer to run a current account surplus, or export more than they import, otherwise, the country is paying out more for the exports than it’s bringing in on its imports. Does this situation sound familiar? The U.S. has had a current account deficit for years, and is financing it by selling off U.S. assets to foreigners. FDI can have a positive effect on a country’s balance of payments because it limits imports. So, instead of buying that Nissan directly from Japan, we’re now making it in Tennessee!
How does FDI affect competition and economic growth? If FDI is in the form of greenfield investment, competition will increase in a market. This should drive down prices and benefit consumers. More competition also promotes increased productivity, innovation, and then, economic growth. We’ve seen huge improvements in world telecommunications for example, since the 1997 WTO agreement to liberalize the industry.
But, what about the costs of FDI? There are three main costs of inward FDI. First, the negative effects on competition within the host country. Second, the negative effects on the balance of payments. And third, the loss of national sovereignty and autonomy that may occur.
Host governments, particularly those of developing countries, worry that the subsidies of foreign MNE’s might end up having greater economic power than indigenous competitors. So, for example, if an MNE supports its subsidiary while it becomes established in the host market, it might be stronger than an indigenous company, and could drive the local company out of business.
When it comes to the balance of payments, host countries worry that along with the capital inflows that come will the FDI, will be the capital outflows that occur when the subsidiary repatriates profits to the parent company. Some countries actually limit the amount of profits that can be repatriated to limit the negative effects of this. Host countries are also concerned that some subsidiaries import a substantial number of their inputs. Of course, these imports will show up in the current account of the balance of payments. Japanese automakers, for example, import from Japan, many of the components they use in their American operations. The companies have responded to criticism about this by pledging to buy more inputs locally.
Sometimes host governments worry that they may lose some economic independence as a result of FDI. They worry that since foreign companies have no particular commitment to the host country, they won’t really worry about the consequences of their decisions on the host country. However, Robert Reich, a former member of the Clinton cabinet, notes that this is really outdated thinking. In today’s interdependent economy, no company maintains strong loyalty to any country.
What about the home country? Are there any benefits from outward FDI? Yes, FDI can help the home country in several ways. It has a positive effect on the capital account because of the inward flow of foreign earnings, there are positive employment effects that come from the foreign subsidiary imports. Remember that Nissan imports a lot of inputs from Japan creating jobs there. There is also the potential to learn valuable skills in the host nation that can then be transferred back to the home country.
What about the costs to the home country that come from outward FDI? As you’ve probably guessed, there are costs associated with balance of payments effects and also with employment. The balance of payments is negatively affected by the initial capital outflow required to finance the FDI, if the purpose of the investment is to serve the home country from a low cost production location, and if the FDI is a substitute for direct exports.
Concerns about FDI’s effect on the balance of payments are linked with the concerns about exports. If FDI effectively replaces home country production, there will be a negative effect on employment.
Keep in mind though, that international trade theory suggests that the concerns about the negative effects of FDI may not be valid. Companies that use offshore production, or FDI undertaken to serve the home market, may actually be freeing up resources that could be used more effectively elsewhere.
So, given that there can be both positives and negatives associated with FDI, how can governments regulate it? Well, there are various ways that home countries can encourage or discourage FDI by local firms. We’ll begin with policies to encourage FDI.
A key reason that firms may resist FDI is because of the risk involved. To minimize this concern, many countries have government-backed programs that cover the major forms of risk like the risk of expropriation, war losses, or the inability to repatriate profits. Some countries have also developed special loan programs for companies investing in developing countries, created tax incentives, and encouraged host nations to relax their restrictions on inward FDI.
To discourage outward FDI, countries regulate the amount of capital that can be taken out of a country, use tax incentives to keep investments at home, and actually forbid investments in certain countries like the U.S. has done for companies trying to invest in Cuba and Iran.
Host countries can also restrict or encourage FDI. Recall that we’ve moved away from the radical stance that discouraged FDI in general and towards a more free market approach, and pragmatic nationalism. To encourage inward FDI, host countries usually offer incentives for investment like tax breaks, low interest loans, or subsidies. Why would countries offer these benefits to foreign firms? Because they want to gain the benefits of FDI that we talked about earlier! Kentucky for example, offered a $112 million package to Toyota to get it to build its U.S. plants in the state!
When a country wants to restrict FDI, it will usually implement ownership restraints or performance requirements. In Sweden for example, foreign companies aren’t allowed to invest in the tobacco industry. Ownership restraints accomplish two things. First, they keep foreign firms out of certain industries on the grounds of national security or competition, allowing the local firms to develop. Second, they help maximize the resource transfer effect and employment benefits that are associated with FDI. In Japan for example, until the early 1980s, most FDI was prohibited unless the foreign firm had valuable technology. Then, the foreign firm was allowed to form a joint venture with a Japanese company because the government believed this would speed up the diffusion of the technology throughout the Japanese economy.
You may be wondering if countries can more or less do as they wish when it comes to FDI, or whether there’s any sort of international agreement on FDI. Until recently, there hasn’t been any consistent involvement by multinational institutions on how FDI should be handled, but in 1995, the WTO got involved through its agreement on services. Remember, that in order to sell services internationally, FDI is often required. So, as you might expect, the WTO is pushing for the liberalization of regulations governing FDI. Already, agreements on the liberalization of telecommunications and financial services have been reached.
So, what does all of this mean for international businesses? There are several implications for companies.
We know, of course from Dunning’s theory that FDI may make sense for location reasons, but the theories can also help firms identify the trade-offs between exporting, licensing, and foreign direct investment. For example, we know that exporting will be preferable to licensing as long as transportation costs and trade barriers are low.
We also know that licensing isn’t attractive when the firm has know-how that can’t be properly protected by a licensing agreement, when the firm needs control over a foreign entity in order to maximize profits, and when the firm’s skills and capabilities aren’t amenable to licensing. In fact, licensing is going to be most likely in fragmented, low-tech industries where globally dispersed manufacturing isn’t an alternative. So, for companies like McDonald’s, which use the service-industry version of licensing, franchising, licensing or franchising makes sense. McDonald’s is current in the midst of a major expansion in in China, Japan, and Russia.
As you can see, firms must consider transportation costs and whether know-how is amenable to licensing as they explore the costs and benefits of different market entry modes. When transportation costs are low, exporting can make sense. When transportation costs are high, a firm may turn to licensing, at least as long as the know how is amenable to the process.
We also know that a government’s policy toward FDI can be an important factor in decisions about where to locate foreign production facilities. Clearly, firms will prefer to establish operations in countries with permissive attitudes toward FDI, like the U.S. We also know that firms may be able to negotiate with foreign governments and receive favorable terms for their investments like Toyota did when it invested in Kentucky.
Now, let’s see how well you understand the material in this chapter. I’ll ask you a few questions. See if you can get them right. Ready? Question 1: A company that establishes a new operation in a foreign country has made an acquisition a merger a greenfield investment a joint venture If you picked C, you’re right!
Question 2: Which of the following statements is true? Over the years, there has been a marked decrease in the stock and flow of FDI Over the years, there has been a marked increase in the stock and flow of FDI Over the years, there has been a marked decrease in the stock and an increase in the flow of FDI Over the years, there has been a marked increase in the stock and a decrease in the flow of FDI If you picked B, you’re correct!
Question 3: Advantages that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets are First mover advantages Location advantages Externalities Proprietary advantages The correct answer is B. Did you get it right?
Question 4: Benefits of FDI include all of the following except The resource transfer effect The employment effect The balance of payments effect National sovereignty and autonomy Did you pick D? I hope so!
Introduction Question: What is foreign direct investment? Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign country Once a firm undertakes FDI it becomes a multinational enterprise There are two forms of FDI 1. A greenfield investment - the establishment of a wholly new operation in a foreign country 2. Acquisition or merging with an existing firm in the foreign country 7-3
FDI in the World Economy There are two ways to look at FDI 1. The flow of FDI - the amount of FDI undertaken over a given time period 2. The stock of FDI - the total accumulated value of foreign-owned assets at a given time Outflows of FDI are the flows of FDI out of a country Inflows of FDI are the flows of FDI into a country 7-4
Trends in FDI Both the flow and stock of FDI in the world economy have increased over the last 20 years FDI has grown more rapidly than world trade and world output because firms still fear the threat of protectionism the general shift toward democratic political institutions and free market economies has encouraged FDI the globalization of the world economy is prompting firms to undertake FDI to ensure they have a significant presence in many regions of the world 7-5
The Direction of FDIHistorically, most FDI has been directed at the developednations of the world, with the United States being a favoritetargetFDI inflows have remained high during the early 2000sfor the United States, and also for the European UnionSouth, East, and Southeast Asia, and particularly China,are now seeing an increase of FDI inflowsLatin America is also emerging as an important region forFDI 7-7
The Direction of FDIFigure 7.3: FDI Inflows by Region ($ billion), 1995 -2008 7-8
The Direction of FDI Gross fixed capital formation - the total amount of capital invested in factories, stores, office buildings, and the like all else being equal, the greater the capital investment in an economy, the more favorable its future prospects are likely to be FDI can be seen as an important source of capital investment and a determinant of the future growth rate of an economy 7-9
The Direction of FDI Since World War II, the U.S. has been the largest source country for FDI Other important source countries - the United Kingdom, the Netherlands, France, Germany, and Japan these countries also predominate in rankings of the world’s largest multinationals 7-10
The Direction of FDIFigure 7.5: Cumulative FDI Outflows ($ billions), 1998 - 2008 7-11
The Form of FDI Most cross-border investment involves mergers and acquisitions rather than greenfield investments Acquisitions are attractive because they are quicker to execute than greenfield investments it is easier and less risky for a firm to acquire desired assets than build them from the ground up firms believe they can increase the efficiency of an acquired unit by transferring capital, technology, or management skills 7-12
Theories of FDI Question: Why do firms prefer FDI to either exporting (producing goods at home and then shipping them to the receiving country for sale) or licensing (granting a foreign entity the right to produce and sell the firm’s product in return for a royalty fee on every unit that the foreign entity sells)? Answer: To answer this question, we need to look at the limitations of exporting and licensing, and the advantages of FDI 7-13
Theories of FDI1. Limitations of Exporting - an exporting strategy can be limited by transportation costs and trade barriers when transportation costs are high, exporting can be unprofitable foreign direct investment may be a response to actual or threatened trade barriers such as import tariffs or quotas 7-14
Theories of FDI2. Limitations of Licensing - has three major drawbacks Internalization theory (also known as market imperfections) suggests 1. it may result in a firm’s giving away valuable technological know-how to a potential foreign competitor 2. it does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitability 3. It may be difficult if the firm’s competitive advantage is not amendable to licensing 7-15
Theories of FDI3. Advantages of Foreign Direct Investment - a firm will favor FDI over exporting when transportation costs are high trade barriers are high A firm will favor FDI over licensing when it wants control over its technological know-how it wants over its operations and business strategy the firm’s capabilities are not amenable to licensing 7-16
The Pattern of FDI It is common for firms in the same industry to 1. have similar strategic behavior and undertake foreign direct investment around the same time 2. direct their investment activities towards certain locations at certain stages in the product life cycle 7-17
The Pattern of FDI1. Strategic Behavior Knickerbocker explored the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms) Knickerbocker - FDI flows are a reflection of strategic rivalry between firms in the global marketplace This theory can be extended to embrace the concept of multipoint competition (when two or more enterprises encounter each other in different regional markets, national markets, or industries) 7-18
The Pattern of FDI2. The Product Life Cycle Vernon - firms undertake FDI at particular stages in the life cycle of a product they have pioneered firms invest in other advanced countries when local demand in those countries grows large enough to support local production firms then shift production to low-cost developing countries when product standardization and market saturation give rise to price competition and cost pressures 7-19
The Eclectic Paradigm Dunning’s eclectic paradigm - in addition to the various factors discussed earlier, two additional factors must be considered when explaining both the rationale for and the direction of foreign direct investment location-specific advantages - that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets externalities - knowledge spillovers that occur when companies in the same industry locate in the same area 7-20
Political Ideology and FDI Ideology toward FDI has ranged from a radical stance that is hostile to all FDI to the non-interventionist principle of free market economies Between these two extremes is an approach that might be called pragmatic nationalism 7-21
The Radical View The radical view - the MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries The radical view has been in retreat because of the collapse of communism in Eastern Europe the poor economic performance of those countries that had embraced the policy the strong economic performance of developing countries that had embraced capitalism 7-22
The Free Market View The free market view - international production should be distributed among countries according to the theory of comparative advantage the MNE increases the overall efficiency of the world economy The United States and Britain are among the most open countries to FDI, but both reserve the right to intervene 7-23
Pragmatic Nationalism The pragmatic nationalist view is that FDI has both benefits, such as inflows of capital, technology, skills and jobs, and costs, such as repatriation of profits to the home country and a negative balance of payments effect According to this view, FDI should be allowed only if the benefits outweigh the costs countries in the European Union try to attract beneficial FDI flows by offering tax breaks and subisides 7-24
Shifting Ideology In recent years, there has been a strong shift toward the free market stance creating a surge in the volume of FDI worldwide an increase in the volume of FDI directed at countries that have recently liberalized their regimes 7-25
Benefits and Costs of FDI Question: What are the benefits and costs of FDI? Answer: The benefits and costs of FDI must be explored from the perspective of both the host (receiving) country and the home (source) country 7-26
Host Country Benefits The main benefits of inward FDI for a host country are 1. the resource transfer effect 2. the employment effect 3. the balance of payments effect 4. effects on competition and economic growth 7-27
Host Country Benefits1. Resource Transfer Effects FDI can bring capital, technology, and management resources that would otherwise not be available2. Employment Effects FDI can bring jobs that would otherwise not be created there 7-28
Host Country Benefits3. Balance-of-Payments Effects A country’s balance-of-payments account is a record of a country’s payments to and receipts from other countries The current account is a record of a country’s export and import of goods and services a current account surplus is usually favored over a deficit FDI can help achieve a current account surplus if the FDI is a substitute for imports of goods and services if the MNE uses a foreign subsidiary to export goods and services to other countries 7-29
Host Country Benefits4. Effect on Competition and Economic Growth FDI in the form of greenfield investment increases the level of competition in a market drives down prices improves the welfare of consumers Increased competition can lead to increased productivity growth product and process innovation greater economic growth 7-30
Host Country Costs There are three main costs of inward FDI 1. the possible adverse effects of FDI on competition within the host nation 2. adverse effects on the balance of payments 3. the perceived loss of national sovereignty and autonomy 7-31
Host Country Costs1. Adverse Effects on Competition The subsidiaries of foreign MNEs may have greater economic power than indigenous competitors because they may be part of a larger international organization the MNE could draw on funds generated elsewhere to subsidize costs in the local market doing so could allow the MNE to drive indigenous competitors out of the market and create a monopoly position 7-32
Host Country Costs2. Adverse Effects on the Balance of Payments There are two possible adverse effects of FDI on a host country’s balance-of-payments 1. with the initial capital inflows that come with FDI must be the subsequent outflow of capital as the foreign subsidiary repatriates earnings to its parent country 2. when a foreign subsidiary imports a substantial number of its inputs from abroad, there is a debit on the current account of the host country’s balance of payments 7-33
Host Country Costs3. National Sovereignty and Autonomy FDI can mean some loss of economic independence key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control 7-34
Home Country Benefits The benefits of FDI to the home country include 1. the effect on the capital account of the home country’s balance of payments from the inward flow of foreign earnings 2. the employment effects that arise from outward FDI 3. the gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country 7-35
Home Country Costs The most important concerns for the home country center around 1. The balance-of-payments The balance of payments suffers from the initial capital outflow required to finance the FDI The current account is negatively affected if the purpose of the FDI is to serve the home market from a low-cost production location The current account suffers if the FDI is a substitute for direct exports 7-36
Home Country Costs2. Employment effects of outward FDI If the home country is suffering from unemployment, there may be concern about the export of jobs 7-37
International Trade Theory and FDI International trade theory - home country concerns about the negative economic effects of offshore production (FDI undertaken to serve the home market) may not be valid FDI may actually stimulate economic growth by freeing home country resources to concentrate on activities where the home country has a comparative advantage consumers may also benefit in the form of lower prices 7-38
Government Policy and FDI FDI can be regulated by both home and host countries Governments can implement policies to 1. encourage FDI 2. discourage FDI 7-39
Home Country Policies1. Encouraging Outward FDI Many nations now have government-backed insurance programs to cover major types of foreign investment risk can encourage firms to undertake FDI in politically unstable nations Many countries have also eliminated double taxation of foreign income Many host nations have relaxed restrictions on inbound FDI 7-40
Home Country Policies2. Restricting Outward FDI Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time countries manipulate tax rules to make it more favorable for firms to invest at home countries may restrict firms from investing in certain nations for political reasons 7-41
Host Country Policies1. Encouraging Inward FDI Governments offer incentives to foreign firms to invest in their countries motivated by a desire to gain from the resource- transfer and employment effects of FDI, and to capture FDI away from other potential host countries 7-42
Host Country Policies2. Restricting Inward FDI Ownership restraints and performance requirements are used to restrict FDI Ownership restraints -exclude foreign firms from certain sectors on the grounds of national security or competition local owners can help to maximize the resource transfer and employment benefits of FDI Performance requirements - used to maximize the benefits and minimize the costs of FDI for the host country 7-43
International Institutions and FDI Until recently there has been no consistent involvement by multinational institutions in the governing of FDI The formation of the World Trade Organization in 1995 is changing this The WTO has had some success in establishing a universal set of rules to promote the liberalization of FDI 7-44
Implications for Managers Question: What does FDI mean for international businesses? Answer: The theory of FDI has implications for strategic behavior of firms Government policy on FDI can also be important for international businesses 7-45
The Theory of FDI The location-specific advantages argument associated with Dunning help explain the direction of FDI However, internalization theory is needed to explain why firms prefer FDI to licensing or exporting exporting is preferable to licensing and FDI as long as transportation costs and trade barriers are low 7-46
The Theory of FDI Licensing is unattractive when the firm’s proprietary property cannot be properly protected by a licensing agreement the firm needs tight control over a foreign entity in order to maximize its market share and earnings in that country the firm’s skills and capabilities are not amenable to licensing 7-47
The Theory of FDIFigure 7.6: A Decision Framework 7-48
Government PolicyA host government’s attitude toward FDI is important indecisions about where to locate foreign production facilitiesand where to make a foreign direct investmentA firm’s bargaining power with the host government ishighest when the host government places a high value on what the firm has to offer when there are few comparable alternatives available when the firm has a long time to negotiate 7-49
Classroom Performance SystemA company that establishes a new operation in a foreigncountry has madea) An acquisitionb) A mergerc) A greenfield investmentd) A joint venture 7-50
Classroom Performance SystemWhich of the following statements is true?a) Over the years, there has been a marked decrease inthe stock and flow of FDIb) Over the years, there has been a marked increase in thestock and flow of FDIc) Over the years, there has been a marked decrease inthe stock and an increase in the flow of FDId) Over the years, there has been a marked increase in thestock and an decrease in the flow of FDI 7-51
Classroom Performance SystemAdvantages that arise from using resource endowments orassets that are tied to a particular location and that a firmfinds valuable to combine with its own unique assets area) First mover advantagesb) Location advantagesc) Externalitiesd) Proprietary advantages 7-52
Classroom Performance SystemBenefits of FDI include all of the following excepta) The resource transfer effectb) The employment effectc) The balance of payments effectd) National sovereignty and autonomy 7-53