Article Review Fdi

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Review of article on FDI and multinationals (A.T. Tavares, et al.)

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Article Review Fdi

  1. 1. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 IntroductionWith rapid advancement of global trade, FDI has been a subject of keen interest of research forscholars world-wide. The mentioned article studies in detail various researches which have beendone on the subject of FDIs, the underlying patterns, their impact and the policy framework 1suggestions on home country and host country governments. In order to absorb and examine thenuggets of useful information which the authors have presented it is important to have re-capitulation of the basic nature of FDI including the drivers of FDI, classification & impacts of FDI on afirm are required.In order to therefore examine the subject, the authors therefore propose to divide the followingpaper into seven sections 1. FDI : Firm specific drivers to internationalize. In this section we propose to discuss the key drivers that leads a firm to internationalize through FDI route. 2. FDI: Classification. We propose to understand the nature of FDI through classifying it as per various points-of-view which will help us to view FDI and its impact in different perspective. 3. Host Country Perspective. National Welfare, development of comparative advantages. 4. Home Country Perspective. Comparative Advantage and therefore welfare and enhancement of trade 5. Policy framework 6. Conclusions Authors: Pallav Vikash Chatterjee Debajyoti Saha
  2. 2. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 Foreign Direct Investments (FDI): Firm specific drivers to internationalize The basic rationale for Foreign Direct Investments (or FDI) by any firm in global market economy is to increase and / or protect their profitability and /or capital value. One of the most common ways through which firms are achieving this goal is by engaging into FDI, either to better exploit their existing competitive advantages1 or to safeguard, increase or to add to these advantages. (UNCTAD, 2006) 2 Although there can be host of conditions of political & economic nature that drives the firms to invest in foreign countries, but often the three most important determinants drive the firms to engage in FDI. Firstly, it is the smallness of their home market. Through the path of growth of the firm and with increasing internal scale & scope economies, the firms no longer find themselves able to achieve those advantages within the boundaries of home country. This happens because of higher production surpluses vis-a-vis the home country demand they start seeking the cost economies by expanding outside the national boundaries. Though initially exports provides a logical extension of domestic business activities to exploit the scale economies and utilize the larger international demand, it becomes imperative very soon for the firm to engage in internalization of various foreign-based essential activities critical to expanding consumption of its goods and services in international markets. Key activities could be marketing, finance, distribution, supply chain & other such functions managing which, may become increasingly difficult & complex with increasing geographic, economic & political variations between country to country. With such growing complexities and increasing difficulties of control, the firms may seek internalization of such activities in foreign countries so as to complement its comparative advantages to expand the consumption and hence business of its goods and services. The most often used route to acquire control over these functions is by route of FDI, investing in these functions critical to further growth of their business. Till so far, we have been concerning ourselves regarding smallness of the home country from demand-side, however, supply-side smallness can also be a factor equally important triggering the firm to seek for seeking international assets by way of FDI. A very pertinent example could be that of Indian Multinational ONGC Videsh, a state owned firm which has acquired assets in countries in Central Asia for instance for the purpose of exploration of Oil & Natural-Gas resources. Due to smallness or lack of endowment of the home country in key resources (Human Resource, Technological Assets, Institutional frame-work, Infrastructural resources, Natural Resources and in some cases even Land, etc) the firm may seek to look beyond national boundaries to acquire these resources through or make itself available intermediate goods in upstream value-chain through acquiring strategic assets in foreign countries by way of investing through FDI.1 Competitive advantage here refers to both Firm Specific Advantages as well as Comparative Advantage of thehome country in terms of resource endowments and opportunity costs, as both FSA and ComparativeAdvantages enable the firm to compete profitably in foreign countries.
  3. 3. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16Secondly, during the advanced phases of product-life-cycle (later phases of growth, shake-off,maturity & decline) the competitive pressures build upon the firm posing a threat to sustenance oftheir profitability. Under these stages of product life cycle, the firm finds the need of expandingoutside the home country (Vernon, 1979). The important conclusion of this point of view had beenthat as the product progresses through the product-life-cycle the geographical location of firmspecific activities with regard to the product changes. In the introduction phase when the productdemand is small & the firm concentrates on its home market. But as it passes through the life-cycle, 3getting increasingly matured, the firm increasingly learning on more efficient methods ofproduction, scale economies rise, competition pressures build up with competition imitation of theprocesses & learning the proprietory knowledge that firm had earlier enjoyed, it becomesimperative for the firm to source its production from foreign countries with lesser costs of resourcesand maintain its advantage over competition.Thirdly and very importantly, Government too has a role to play in encouraging and driving the firmsto internationally expand. A variety of drivers may encourage the firms to internationalize andengage in acquiring assets in foreign country and Government policy framework may facilitate totrigger the process. Government as an institution employs people whose job is to look out for thewelfare of the state and protect the sovereignty of the nation. FDI in its both forms (inward andoutward) is deeply interlinked with the both aspects of effective national governance; therefore byvirtue of its role in the country, government plays an important role in both in-bound and out-boundFDI. With rapid growth of FDIs and its impact on host countries as well as home countries, the articleexamines the various policy stance being taken by governments to promote FDI, both outward aswell as inward. However, the article mentions various ongoing debates and researches which areunderway on these policy issues on impact of the benefit to the nations concerned.The FDI drivers/motivators can therefore be summarized in following table a) Cost or Competitive Advantage or Economic Factors – Desire to be near supply sources, low cost of labour, productivity of labour, costs and availability of raw materials, Transportation costs, other financial benefits, infrastructure availability, Agglomeration (or in other words External Economies of scale), Technology development, etc. ( see also World Investment Report, 1998) b) Market Factors – Position in product-life-cycle, market size & growth, desire to maintain market share, desire to follow customers, desire to follow or outshine competition, establish export base, networking with customer base, etc. (Vernon , 1979) c) Government Policy, Political & Environment Factors – Policy inducements / incentives, tax policy, exchange rate stability, government attitude towards FDI, SEZs, availability of LIS (Local Industrial Set-ups), etc.
  4. 4. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 FDI: Nature & ClassificationOf the two types of investment flows between nations – Portfolio investment and foreign directinvestment (FDI) – we are concerned primarily with FDI, because it is the ultimate stage ofinternationalization, and encompasses the widest range of international business development. FDIis the foreign entry strategy practiced by the most internationally active firms. Companies usuallyengage in FDI for the long term, and retain partial or complete ownership of the assets they acquire. 4In event of a firm deciding to look for business opportunities outside its national boundaries, itschoice of strategy comes down to one of the three approaches – Export, Contracting (Licensing ormanagement contract) or Own and control assets abroad. It is the last entry choice which ispopularly referred to as FDI. Therefore, FDI can be classified by way of choice of firms to enter aninternational market that can be by way through following modes. a) Joint Venture, which is primarily a collaborative & jointly owned approach with another firm with sharing of financial stakes, assets & investments. b) Majority Ownership (or Subsidiary) where the firm chooses to acquire assets wholly by itself either by way of Greenfield investment (building assets de novo) or acquiring a foreign asset by way of Mergers & Acquisitions.Generally it is observed that firms prefer merger & acquisitions over green field investments becauseM&A are quicker to execute. Another reason can be foreign target firms can have valuable strategicassets like trademarks or patents, brand loyalty, production systems, customer relationships,distribution systems and so on. Also acquiring firms believe that they can increase the efficiency ofthe acquired unit by transferring technology, capital or management skills.Primarily FDI is used for strategic activities, including : a) To set up manufacturing or assemblyoperations, or other physical facilities; b) To open a sales or representative office or other facility toconduct marketing or distribution activities; c) To establish a regional headquarters. In the processthe firm establishes a new legal business entity, subject to the regulations of the host government.There has been dramatic growth of FDI into various world regions since the 1980s and the trendremains strong and, over time, is growing. The FDIs may be categorized on the basis of their source& destination countries, following classification holds well on that basis2 :2 Detailed statistics of the extent and impact of various forms are available in World Investment Report, 2006,UNCTAD , Chapter III, pp. 105-139
  5. 5. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 a. Developed Countries to Developed Countries b. Developed Countries to Developing Countries c. Developing Countries to Developed Countries d. Developing Countries to Developing Countries 5The FDIs concerning the developing countries is one which is of keen interest of researchers incurrent day scenario as the volume of FDIs flowing out of developing countries have started growingrapidly and has grown on to almost $1.4 trillion or 13% of the total global outward FDI stock(UNCTAD, 2006). The FDI pattern of distribution in among the developing countries is illustrated inthe graphical illustration 1.Graphical illustration 1 (Source : UNCTAD)FDI activities can even be classified based on firm’s motives for engaging in acquisition of foreignassets. These may be a) Resources seeking FDI : To serve local and regional demand. Reason for market-seeking FDI projects may be explained by the relative production and transaction costs of servicing markets through export or local production. Especially economies of scale, transportation costs, and exchange rates may influence the trade-off between exports and foreign production. Firms with low degrees of plant-level economies of scale and high transportation costs are more inclined to undertake market-seeking FDI projects. Need to stay closer to customers is another objective
  6. 6. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 b) Market seeking FDI: Objective of resource seeking FDI is to exploit comparative advantages of the host country. Firms can allocate production resources in countries where factor prices are low relative to firm’s productivity. Another advantage may be access to raw materials, part and components. c) Knowledge seeking FDI: Such FDI projects are undertaken to maintain or develop a better competitive position in certain product or geographical markets. This competitive 6 position can be achieved by acquiring technological knowledge and capabilities and management expertise d) Efficiency seeking FDI: The purpose of efficiency seeking FDI projects is to rationalize the structure of established production units in such a way that a firm can benefit from the common governance of economic activities in different locations. Efficiency seeking FDI projects tend to occur in capital or technology intensive sectors in which the advantages of intra-industry and intra firm trade are the most prevalent. Firms in these sectors tend to differentiate their products as a form of competitive advantage. Potential benefits like economies of scale and economies of scope can be derived from product and geographical concentration and from process specialization. In efficiency-seeking FDI projects, the advantages of exploiting economies of scale and scope predominate over the importance of relative factor endowments across countries. e) Risk reduction seeking FDI: Risk reduction-seeking FDI projects are designed to reduce the corporate risk associated with unfavourable changes in macroeconomic variables, changes in supply and demand among national markets and the moves of competitors and of national and regional governments. These FDIs represent internal hedging activities conducted in order to reduce the level of corporate risk. Minimizing the firm’s exchange rate exposure is an important goal for risk reduction seeking FDIs. For instance, firms may handle exchange rate risk by moving production from unfavourable to favourable locations.The Trans-National Corporates (TNCs) therefore guided by above motive factors engage themselvesin FDI in foreign countries, however eventually the decisions of engaging in FDI, with any of themotives as above eventually leads the firms to enhanced profitability, higher net present value ofthe future cash-flows & sustained competitive advantage which get possible to the firm as a wholethrough such investment decisions and these remains the essential benchmarks for them toevaluate the performance of the decision.
  7. 7. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 Host Country Perspective : Concerns & Impact of Inward FDIConcernsGovernment concerns on MNE on national welfare & sovereigntyRole of government is primarily concerned with national welfare and protection of sovereignty ofthe nation. Any external force or obstacle to these objectives are seen by the governments as 7threat. However, in the case of interactions between the nation state and MNEs, the threat and sothe reaction is also subtle as well. Governments worry that if MNEs gain control of strategic nationalassets and resources (e.g., oil, gas, metals, forests), they may not be able to control development oftheir own resources. In extreme cases governments might worry that they might be held hostageand forced to incur costs via lower taxes, or credits or subsidies provided to the MNE. For example,Saudi Arabia sought to ensure that Western oil firms had explicit plans to guarantee the transfer oftechnical capabilities to local employees, so that the foreign MNEs could not have an unacceptablelevel of influence over oil production in the country. Governments also view MNEs as potentialthreats to their independence if they become too strong as suppliers of critical resourcesConcerns about impact on domestic firmsThe competitive pressures on domestic firms can be too severe on country’s domestic firms due totechnological, capital and human resource advantages. Although many governments doacknowledge that domestic firms need to adjust by either becoming more competitive or going outof existence, the political pressures however may be too high in order to provide for protection todomestic firms. Consequently research suggests governments are concerned about effects of FDIand MNEs particularly on two types of domestic firms. Firstly, the firms in declining industries wherethere may be structural reasons (for example, cheaper natural resources or labour in anothercountry), that may be at the heart of the decline of a particular industry and beyond the control ofthe government. We see similar pressures on US textile and automobile industries, for example.Secondly, governments are worried about firms in promising and embryonic industries. Newindustries provide opportunity of income growth, higher productivities. FDI and MNE activities mayhave the ability to destroy domestic firms in emerging industries due to their higher scales and costeconomies. In either cases government policies may not allow the MNEs to compete profitably inthe host country.Concerns about hidden valueGovernments are concerned about MNEs hiding value. One of the most obvious such concerns arethat the government have about MNEs is that they will hide profits and thereby avoid tax liability.Because of their global networks, MNEs can move the profits from a high tax-rate country to a lowtax-rate country through fees and transfer pricing policies. While this may be attractive to MNEs but
  8. 8. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16host governments may perceive this to be unfair and often illegal. Governments are also concernedthat MNEs will hide value by keeping advanced technology out of their countries. MNEs may achievethis either by assigning low-technology tasks to operations within a certain country and by keepinghigh-value added activities and benefits from the local economy or MNEs can keep high technologyby keeping high technology out the hands of local employees by assigning expatriate managers andtechnical specialists to the subsidiary. Consequently, governments employ policies that require highvalue-added technology to be incorporated into FDI proposals or limit the number, type andduration of expatriate employees. 8Concerns about responsibilityGovernments also worry about the social responsibility of MNEs. To the extent that MNEs areviewed as “temporary” visitors in countries, with no long-term commitment to raising the standardof living of citizens, governments worry about these firms exploiting opportunities and not beingaround for longer-term negative consequences. For example, governments worry about MNEs innatural resource extraction industries taking resources in the most economically efficient meanspossible with little regard for environment consequences, worker safety, or societal health andwelfare. If disasters happen the individuals responsible may escape the arms of local justice or evenmay be transferred out of the country by the MNE before the government can assess responsibility,of the MNE may simply protect the people at headquarters who were responsible for formulatingand implementing the decisions that led to the disaster and its consequences. This issue, forexample is central to the continuing dispute of between Union Carbide and the government of Indiaconcerning the Bhopal tragedy.Impact and benefits to host economyEconomic cost benefit (Mathematical approach)More often than not a government might not simply view the benefit of FDI in terms of the cash-flow projections of an MNE engaging in FDI into the nation. In a competitive and free marketeconomy where there is no restriction on information, prices, entry barriers, both MNEs andgovernment can use the same sets of projections as measures of benefit to both the MNEs and thesociety. However, externalities may exist which may restrict the free competitive market structureand as a result there may happen to be price controls, wage restrictions , subsidies, tariffs, taxes andother imperfections distorting values and therefore the cash flow projections of MNEs no longerproject the true value (or opportunity cost) of a resource to the society. As a consequence, thegovernment’s perspective of looking at an FDI proposal may vary from that of an MNE. As a commonapproach governments look at maximization of national income as economic implication of FDI. Forlooking at the benefits that accrue to the host economy, the governments of host economiestherefore use variety of tools to appraise the benefits to the economy from inward flow of FDI.These tools may be Benefit-Cost Ratio, Present value of costs and benefits, Shadow priceadjustments and time-context based value.
  9. 9. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 a) Benefit-cost ratio The basic benefit cost ratio may be expressed as follows [{F+R*+T} – O + N] / E Where F = the local factor payments that the MNE pays to labour, management and land (wages, salary & rent) R* = the after tax payments to local capital (profits, dividends, interest) 9 O = opportunity cost of local factors N = net external economies, these are spill-over effects of benefit on local economy which can be positive ( forcing domestic firms to adopt better quality, lower prices, higher employment, etc) or negative (structural unemployment or discouragement of local entrepreneurs) E = payments to external factors of production including technology (profits, dividends, interest, royalties, management fees, and so on that gets transferred out of the country) b) Present Value of costs and benefits To calculate present value of streams of flow of costs and benefits that occur over a period of time an appropriate discount rate needs to be applied. However, because private and social values differ in a situation of market imperfections, the private and social discount rates also differ. An MNE will select an appropriate discount rate which will be risk adjusted and that may equal to the marginal opportunity costs of its capital (FDI invested) adding a risk premium to account for political risks. Government however, will seek to maximize the income effects on the economy by the proposed FDI and therefore select a discount rate that will reflect the marginal productivity of capital in its economy. Since governments are always under pressure for accumulating foreign exchange, controlling inflation or reducing unemployment, they will tend to assign higher discount value to near-term benefits than longer term benefits while appraising a proposal of FDI. c) Shadow price adjustments and benefit – cost analysis Shadow prices are intended to measure accurately the opportunity costs of various inputs and the utility of the outputs to the society. In determining the revenue benefit to the firm, the MNE would simply calculate the nominal sales expected to be generated. The value of these outputs to the society can differ from the MNE’s estimate. If the output is import substituting then the value of the output is the same as the value of the imports and vary from the MNEs simple calculation of nominal sales because of reasons like import tariffs that makes the domestic prices differing from the import prices (world prices). Export-generating output also very similarly is to be valued on the basis of world market price rather than domestic price. In addition to these adjustments, specially in countries with
  10. 10. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 fixed exchange rate regimes or policy intervention framework in exchange rates, a necessary correction needs to be made on basis of shadow-exchange-rate (unofficial exchange rate) that may determine the real value of the output in domestic currency terms. In many cases domestic currency is overvalued or undervalued under policy interventions, in such cases the real value of the costs / benefits of the FDI in foreign currency terms should be translated to local currency terms using the unofficial shadow-exchange-rate that determines more accurately the real value of the currency and therefore the benefit or the cost of the activity to the society. 10 d) Time-context based value of the benefit-cost to the society During the first few years after the firm has engaged in FDI, the firms would usually expect lower cash-flows or profits. During the course of these initial years, extent of inward investments would be higher, when the firm (MNE) will be building up capacities, transferring technologies, provide employment by recruiting staff / labour, providing training to local manpower, etc. During these early years there will be efforts from the firm to build higher scales to ensure economies in costs. However, over a period of time these inflows will reduce in a continuum as the FDI project matures and the benefits to the firm increase with growing scales. However, on the contrary government (society) may perceive the benefits higher in the initial years and the perception of benefit of the FDI may reduce with passage of time as the inward flow of these economic benefits continue to reduce. The phenomenon is illustrated in figure 2 exhibited below. This phenomenon may create a zone of disagreement between benefit perception to the firm and the benefit perception to the host economy (society or government). Graphical Illustration 2Apart from the above concerns and divergent views of appraisal of FDI benefits and costs to thesociety in economic value terms it is well known to have positive benefits of FDI on host economy.The benefits to the host country can be summarized as below.
  11. 11. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 a) Primary contributions. These may include following • Lower price due to competitive advantage of parent MNEs. • Higher quality & differentiation • Inflow of additional resources – Capital, Technology & Management skills which raise the efficiency and volumes of domestic output • Export enhancement – specially in case of FDI in export oriented units, 11 where the MNEs invest to exploit resources in host country to provide for intermediate inputs to its various facilities in global network. The benefit even accrues in case of finished good exports by MNEs (for instance small cars from India, computers & electronic goods from China). MNEs may benefit by achieving cost and competitive advantages due to technological or factor cost advantages from the host economy while host economy benefits in income growth through export enhancement. • Agglomeration effects – FDI in economically laggard areas, if directed through conscious policy and institutional framework support by local government may have a spiralling virtuous effect of developing external scale economies and local entrepreneurship in order to develop agglomeration effects & hence rise in the economic welfare and growth of the area in the host economy. This may be achieved where FDI by MNEs may be attracted where MNEs benefit by lower factor costs, availability of specific input resources and government incentives and subsidies. Early start in such cases or import restrictions on certain goods and services which are governed by external scale economies, may provide this form of welfare advantage to the host economy. The MNE may bring in technological expertise, develop SMEs & suppliers, support industries in the agglomeration as a result of the FDI. b) Secondary benefits • Production enhancement: The MNE may benefit the host economy by providing demand of inputs from the local suppliers. For instance, local auto component suppliers for a car company. • Demand Creation: There can be instances when the MNE creates demands for goods for its subsidiary in the host country in world market (or home country market for the parent firm) for the parent firm units to source critical supplies.
  12. 12. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 c) Externalities • Enhancing productivity of host country firms through introduction of new technologies, opening international channels of sourcing for more efficient supplies of input goods etc. • Foreign investors provide host country firms that originate as suppliers 12 new opportunities to become producer of goods/services to other buyers in the international economy. For example, Malaysian machine tool firms that originated selling equipment and services to INTEL in Malaysia follow the MNC to China, and begin to sell equipment and services to US, Europe, and Japanese firms in Chinese market.
  13. 13. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 Home Country Perspective : Outward FDIFDIs have positive effects on the home country (originating country), some of these advantages havebeen reported by firms as per UNCTAD survey (see Graphical illustration 3 at the end of the section),to be market expansion, efficiency gains, obtaining strategic assets, access to natural resources andfinancial gain. Principally, outward FDI helps the home country to utilize its comparative advantageand maximize welfare through mobility of factors and by the effects of specialization. FDI may form 13an alternative to productive specialization through trade when there are constraints that limit tradeto actually take place. These restrictions to trade may trigger mobility of factor (capital resources)and encourage flow of capital from home country in form of FDI. Among variety of such reasons, fewparticularly important are as follows: a) High transportation costs relative to the value of the output of production limiting the effects of benefits of trade. Transportation cost is a function of weight, volume, distance and haulage of transportation carriers involved in transportation of goods. In the cases of goods with low value to weight or value to volume ratios, the transportation cost therefore, will constitute to very high proportion to the final price of the goods sold renderring the opportunity cost advantage irrelevant while competing with other sources of supplies of such goods which are geographically nearer to the final point of consumption. Mineral ores – bauxite or iron ore are such examples. Therefore in order to retain and protect the comparative advantage firms may seek to internalize the specific production processes or resources leading to such goods in the host countries which are either themselves the target markets for consumption or nearer to the points of consumption. This way the firms tend to gain through specialization in the products and processes where they have comparative advantage. b) Higher factor rewards for capital also encourage the firms from the home countries to engage in FDI. For instance reward for capital (rent, profits, dividends, interest etc) encourage the firms to shift capital to the host country where the rewards are higher, thereby taking advantage of the endowment of that specific factor (capital) to gain higher rewards in form of rent, profits, dividends and interests. c) MNEs may have factor specific advantages like efficient production processes (factor combinations, production technologies, Intellectual Property Rights). In order to acquire competitive advantage to compete in global markets efficiently they may require other factors of production at most economic opportunity costs, which may not be available in the home country. Therefore this triggers the MNE to engage in FDI in order to internalize low factors available at comparatively lower opportunity costs in the host countries (for instance cheap labour, raw materials etc). This explains movement of FDI from developed countries to developing countries having lower cost of labour, raw materials, natural resources etc.
  14. 14. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 d) Need for acquisition of technology & efficient production know-how: FDI may also be directed from the home country to acquire technological advantages, advantages of production know-how, efficient production technologies optimizing right mix of inputs to production. This mainly happens in case of FDI originating from LDCs (Less Developed Countries) or emerging markets (South – North FDI, UNCTAD). Such lack of technological advantage may restrict the home country to promote trade and maximize their societal welfare; FDI in such cases maximizes trade opportunities. 14 In addition to above the effect of FDI on the home country can also be on the local business environment of the home economy (point of origin economy of FDI). It refers to subcontracting relations and local externalities induced by the demand for specialized inputs, services, managerial and operative skills and it has to do with supporting firm’s employment effect. In such contexts production in foreign affiliates can induce two effects - firstly, substitutive effect of employment in local context in which the MNE operates due to (i) reduction of domestic low skilled labor, (ii) loss of market shares by local suppliers, loss of opportunity to grow and learn through the relationship with parent firm, (iii) write-off of previous sub contracting relations. This can even happen secondly due to complementary effects which occur whenever the enhanced competitive position of the parent company and its additional demand for specialized inputs do increase the externalities on the local context. Transfer of production abroad may have a positive effect when parent company’s suppliers become suppliers for foreign affiliates. In such a case market for suppliers expands. Resource seeking FDI can induce upgrading in local system and in supply chain competitiveness by promoting differentiation in specialization and competencies between countries. Graphical Illustration 3
  15. 15. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 Policy FrameworkThe article discusses at length on the debates over policy framework issues under practice whichnecessarily the Host country should bring into force and what are the possible effects of thosepolicies on overall effectiveness in promoting national welfare, protection and enhancement ofcompetitive and comparative advantage. 15TrendThe article mentions that there is a current trend by the host countries to incentivize FDI directly orindirectly. Under direct measures of incentivization, there is exemption of taxes, direct subsidies, etcwhile under indirect measures governments are facilitating FDI through cheaper allocation ofresources in the home country like allocating land in SEZs at cheaper rates etc. While the articlementions that incentivization of FDI (directly or indirectly) by any means is not the only or beststrategy to adopt, but this has been mainly due to the “prisoners’ dilemma” effect arising due tonations competing against each other to attract FDI in their respective countries.We have analyzed the perception of benefits & concerns of inward FDI from the host-countrygovernment perspective, where we have concluded that the perceived benefit from FDI to the hostgovernment is the largest in the initial legs of the investment from the benefit-cost point of view.However, over time as the MNE investing in the country gains scale advantages, the perceivedbenefit to the host government slowly starts declining, when there are slowing inflow of benefits interms of capital in-flow, know-how, technology or employment over the period of time withincreasing zone of disagreement between the respective benefits perceived by the host country andthe MNE (reference graphical illustration 2, page no. 10). This indicates that from policy point ofview the host-country governments should not only consider the benefit of FDI in terms of short-term impact to the host economy but longer-term benefits that could be derived upon. Any policyframework that enables to benefit the society in longer term and also benefitting the MNE investingin the country would be the most beneficial policy stand which a government should take.As in the previous section we have considered the short term benefit-cost consideration as in termsof benefits net off all costs (opportunity costs, costs factor payments flowing out of the country), thegovernment should also consider the gains to the economy in enhancing welfare through increasedproductivity, absorptive capacities of local firms, entrepreneurship development, agglomerationbenefits etc triggering from the FDI flowing in. Any policy stand that can help attracting FDI andbenefit the host country in such a fashion should be benefitting the economy the most.Therefore, any policy framework that focuses on attractive FDI only through incentives couldtherefore stands a risk of being a “myopic” policy and such short sighted policy framework may notresult the host-economy to gain maximum advantage from inflow of foreign capital through FDI. Thearticle points out debates on the benefits of FDI on developing local industries in Ireland and similarsuch places where incentives have formed the central part of the strategy to attract FDI.
  16. 16. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16FDI Incentive PoliciesOn the expectation that MNCs will raise employment, exports, or tax revenue, or that some of theknowledge brought by the foreign companies may spill over to the host country private sector, manygovernments have also introduced various forms of investment incentives, to encourage foreignowned companies to invest in their jurisdiction. 16There have been numerous such examples of incentivization by governments to attract inward FDI,some such notable examples are as below. Governments of Britain and France competed with each other on the incentives they offered Toyota to invest in their respective countries. Kentucky in United States offered Toyota an incentive package worth $112 million to persuade it to build its US automobile assembly plants there. The package included tax breaks, new state spending on infrastructure, and low-interest loans. British government provided an estimated $30,000 and $50,000 per employee to attract Samsung & Siemens respectively to the North East of England in 1990s.These incentives can take the following forms - Tax holidays – Low direct (corporate, income tax) or indirect taxes (excise, value added tax etc) - Preferential tariffs - Special Economic Zones / Export Processing Zones - Financial subsidies on investment - Soft loans / loan guarantees - Free land, assets or Infrastructure or alternatively subsidies in such investments. - Job training or employment subsidies - R&D subsidies - Derogation from regulationsAre FDI incentives justified?Host countries apply these measures considering the positive benefits of FDI on the host country andwith the consideration of spill-over effects of FDI on welfare like employment creation, learning ofbest practices & efficient methods of production by the domestic industries.
  17. 17. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16These incentives are therefore extended to the MNEs investing in the host-country considering thesuperiority in terms of foreign firms over the domestic ones in terms of efficiencies, productivities &technology.So far we have discussed how government incentives and policies attract FDI inflows. But it needs tobe investigated whether these incentives are justified. These will be justified only if the host nation issubjected to welfare effects resulting out of FDI inflows. Otherwise these incentives are not worth 17taking.FDIs are expected to generate spillovers which mean the positive effects/benefits emanating fromFDI, which go beyond the direct benefits. Foreign MNCs may: Contribute to efficiency by breaking supply bottlenecks Introduce new know-how by demonstrating new technologies and training workers who later take employment in local firms Improve allocative efficiency by entering into industries with high entry barriers and reducing monopolistic distortions. Also stimulates competition and efficiency Transfer techniques for inventory and quality control and standardization to their local suppliers and distribution channels. Force local firms to increase their quality managerial efforts or to adopt some managerial and marketing techniques used by MNC. Enhance productivity of local firms with knowledge/technology transfer Force domestic firms to modernize by imposing on them minimum standards of quality, delivery dates , prices, etc in their supplies of parts and raw materialsHowever, the article cautions over those policies of FDI attraction (like for instance Incentives)without considering the implied benefits of such FDIs, may be detrimental to the welfare of the host-country. The benefits of inward FDI, for instance is through the absorptive capacities of the localfirms, to gain from the spillover effects of inward FDI. If the absorptive capacities of the local firmsare low or if the structure of the home economy is such that it cannot maximize the learningadvantages from inward FDI, attracting FDI through incentives may cause welfare reduction. Thearticle therefore criticizes such forms of FDI attraction policies on essentially because of folllowingissues a) There are variety of factors that facilitates or restricts the absorptive effects of local firms (learning of best management practices, productivity enhancement etc). Therefore if the inward-FDI is promoted through FDI without due-considerations to those factors which may restrict the absorption by local firms, It may amount to unjustified discriminatory way of reinforcing competitive advantage against domestic producers affecting local industries and therefore reduction of welfare to the host-country economy. b) It may have international crowding out effects. International crowding out effect is expansionary fiscal policies of government due to high incentivization expenses may result in
  18. 18. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 hardening of interest rates, appreciation of local currency affecting exports and therefore undermining the accelerator benefits of Government spending on domestic GDP growth. c) De Propris et al., suggest that incentivizing FDI in Local industrial systems (LIS) is unnecessary unless there are laggard agglomerations (backward areas), as there will be no significant benefit to the welfare of the host-country through absorptive effects of FDI on local firms. d) From various studies it has been concluded that the LCs who are predominantly MNEs or at least who are involved in exports (trade) have greater absorptive capacity than their purely 18 local counterparts. Therefore instead of just considering policy measures to attract inward FDIs, therefore there should be policy adopted for promotion of both inward and outward FDI, which may create maximum welfare through increased absorptive capacities of home- grown MNEs or micro MNEs (SMEs who are internationalizing).Therefore considering above, a more holistic view should be taken by the host governments towardsinward FDI, which may help maximizing economic welfare.
  19. 19. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 Conclusions FDI according to Dunning emerges due to ownership, internalization and locational advantages. Foreign companies will be attracted to the host country if it can seek significant locational advantages in the host country. But with rising pressures of globalization induced competitiveness, the locational advantages based on only the economic conditions may not be able to sustain their strength of attracting FDI. Possessing the principal determinants like 19 market size, real income levels, skill levels, infrastructure and other resources, favorable trade policies and macroeconomic stability may not be sufficient for the host countries to attract FDI. For this matter focus now has shifted to government policies in addition to economic conditions as determinant of FDI. In furtherance, rather than only to concentrate on pulling FDI, if spill-over effects of FDI are not maximized, the activity may bear no fruit of welfare for the economy. Therefore government policies should also be directed inwards towards enhancement of comparative advantages, developing new specializations through development of entrepreneurship, development of specialized agglomerations, development of productivity of factors of production, skill enhancement of local labour, acquisition of new technologies etc. Therefore Government policies should be two pronged, one with a pull strategy which should incorporate attracting FDI through maximizing the Ownership, Locational or Internalization advantages of investing MNEs on other hand it should be directed towards enhancing domestic competition, absorptive capacities of local firms, and development of home-grown MNEs. Pull strategy a) Overall economic policy that increases locational advantages for FDI by improving following economic fundamentals of the host country: Market size: Large market size generates scale economies while growing market improves market potential and attracts FDI. Cost factors: Includes cost of labor, cost of capital and infrastructure costs. Lower wage rates, availability of skilled labor aids FDI. Also lower interest rates increases domestic consumption leading to more FDI inflows. Higher the infrastructure present, lower is infrastructure costs and more will be FDI inflows. Real exchange rates: Foreign investors seem to gain from devalued exchange rate of the host country. They may gain due to larger buying power in host countries. Also they can produce more cheaply and export more easily.
  20. 20. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 Macroeconomic stability: Macroeconomic variables like inflation, budget, balance of payments affect FDI inflows. For instance exchange rate can adversely affect the competitiveness of the plants in different countries. Stability of exchange rates of the currency in host country encourage investment by foreign firms as it increases uncertainty regarding the future economic and business prospects of the host country. 20 Overall economic stability: Financial health of the host economy is capture by the ratio of external debts to exports. It is expected that lower this ratio higher is the probability of economic stability in the country. Resulting in more FDI inflows. b) National FDI policies reduce transaction costs of foreign firms entering the economy: Tariff policies: FDI is deterred by the high tariffs or non tariff barriers on imported inputs and is attracted to more open economies. Higher openness to trade to attract higher FDI inflows. Policies can be categorized into: Fiscal incentives: Reduces tax burden of a firm. It includes tax concessions in the form of reduction of the standard corporate income-tax rate, tax holidays, depreciation allowances on capital taxes, exemption from import duties and duty drawbacks on exports. It also includes provision of guarantee for repatriation of investments and profits and establishing mechanisms for settlements of investment disputes. Financial incentives: These include grants, subsidized loans and loan guarantees, publicly funded venture capital and government insurance at preferential rates. c) Removal of restrictions: Due to the enforcement of TRIMS (Trade Related Investment Measures) many restrictions were eliminated, with removal of such restrictions FDI flows are maximized. Entry barriers Ownership & control restrictions Allowing only fixed portion of foreign owned capital in an enterprise Compulsory joint ventures Mandatory transfer of ownership to local private firms over a period of time Restrictions on reimbursements of capital upon liquidation Restrictions on employment of foreign key personnel, and performance requirements, sourcing, training requirements, export targets.
  21. 21. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 d) Development of institutional framework Institutional framework which facilitates smooth and transparent establishment of new businesses that may facilitate MNEs to smoothly establish their business activities Reforms in licenses, permissions required to establish businesses. Education / Technical skill bases – to provide adequate pool of skilled local labour 21 resources Corruption or Graft – ensuring transparencies in local governance, enhancing investors’ confidence on local business environment and thereby reducing their perceptions of political risks associated with the FDI. Well developed labour policies - trade-unionism, weak labour policies etc in long run have negative impact on investor confidence. Due to non adequate legislations in place on such issues, there are frequent unrests, issues that interrupt regular business & add to the costs to the MNE in investing. Therefore strong legal & institutional framework on such issues helps the MNEs scale the host-country highly on business environment attractiveness. Basile (2004) notes that existence of public research and business services can be used to attract FDIs by MNEs. These existing institutions in the host-country maximizes the locational & cost advantages for the MNEs.Maximization of domestic welfareSpillover (benefits) effects of FDI from MNEs may happen in variety of forms – technological,entrepreneurial, productivity, wages etc. Therefore these policies should act complementarily alongwith the strategies meant to pull FDI. Development of R&D investments to bridge technological gap and therefore enhance spillover effects (Bellak & Nuran) Research suggests geographic proximity as in agglomeration enhances the possibility of spillover effects. Therefore creation of local agglomeration with advantages of external scales of economies which may attract FDI on one hand and on other enhance welfare through spillover effects of FDI. De-propris et al., suggests that there are difficulties in embeddedness of MNEs in clusters due to variety of road-blocks like difficulty in grasping the governance mechanism, idiosyncratic coordination, and adjust to the collective learning system. That is why Piscitello & Rabbiosi provided a practical but controversial suggestion of promoting acquisitions in clusters as already existing firms are more or less embedded in the system and therefore FDI through acquisition by MNEs would accelerate the positive spillover effects.
  22. 22. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16 De Backer and Sleuwaegen support the development of a techno-economic infrastructure aimed at clustering foreign and domestic investments, allied to policies designed to stimulate technological development and international exploitation of technological advantages. These are considered as the best options for the successful development of a sustainable industrial base. While such measures increase the likelihood of spillovers, the authors indicate that there is no guarantee that they will happen automatically. Since studies suggest that presence of domestic MNEs enhances the absorptive 22 capacities, Durán and Úbeda envisage an important role for public policy in stimulating the inward-outward investment dynamic, and that Government action should occur at various levels (short-term, long-term, general and specific, promoting LAs but also the development of Firm Specific Advantages or FSAs in other words, in companies based in their jurisdiction). They further suggest incentives for investments in R&D, technical collaborations and alliances to enhance the absorptive capacity of local firms
  23. 23. Article Review : FDI and Multinationals: Patterns, Impacts and Policies 2011Review of article - FDI and Multinationals: Patterns, Impacts and Policies, A. T. Tavares and S. Young, Int.J. of the Economics of Business, Vol. 12, No. 1, February 2005, pp. 3–16Bibliography 1. UNCTAD , World Investment Report 2006, Chapter IV, pp. 142 2. Vernon, Raymond, Oxford Bulletin of Economics and Statistics 41 (November 1979): 255-267 3. Course Materials 4. Web Resources (Wikipedia) 23

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