All Basic Concepts Of FDI

2. Foreign Direct
Investment

3. Menu of this chapter
• Introduction
• Foreign Direct Investment in the World
Economy
• Theories of FDI
• Political ideology and FDI
• Benefits and costs of FDI
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4. Introduction:
• Foreign direct investment (FDI) occurs when a firm
invests directly in new facilities to produce and/or market
in a foreign country
• the firm becomes a multinational enterprise
• FDI can be in the form of
• Greenfield investments - the establishment of a
wholly new operation in a foreign country
• Brownfield investments - acquisitions or
mergers with existing firms in the foreign country
• The flow of FDI refers to the amount of FDI undertaken
over a given time period
• Outflows of FDI are the flows of FDI out of a country
• Inflows of FDI are the flows of FDI into a country
• The stock of FDI refers to the total accumulated value of
foreign-owned assets at a given time
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5. Foreign direct investment (FDI)
Companies can enter a foreign market either through Exporting or FDI.
Exporting, is a relatively low-risk and simple vehicle with which to
enter a foreign market because it does not involve actual presence in the
target market. While lower in risk, exporting does not enable the
firm to maintain control over foreign production and operations nor
benefit from opportunities available only through
actual presence in a foreign market, which FDI permits
Manufacturing FDI requires an establishment of
production facilities abroad (e.g., Coca-Cola had built bottling
facilities in about 200 countries by 2001), whereas service FDI
requires either building service facilities (e.g., Walt Disney built Disneyland
Europe in 1992, Banking services, Insurance services)
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6. FDI versus Foreign Portfolio
InvestmentForeign portfolio investment (or foreign indirect investment) is
investment by individuals, firms, or public bodies (e.g.,
governments or nonprofit organizations) in foreign financial
instruments such as government bonds, corporate bonds,
mutual funds, and foreign stocks. In other words, FDI is the
investment in real or physical assets such as factories
and facilities, whereas portfolio investment is the investment in
financial assets comprising stocks, bonds, and other forms of debt
Portfolio Theory describes the behavior of individuals or firms
administering large amounts of financial assets in search of
the highest possible risk-adjusted net return.
Fundamental to this theory is the idea that a guaranteed rate of
return (say, 9 percent per year fixed over the next five years) …
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7. Types of FDI
Horizontal FDI occurs when the MNE enters a foreign country
to produce the same product(s) produced at home. It
represents, therefore, a geographical diversification of the MNE's
established domestic product line. Most Japanese MNEs, for
instance, begin their international expansion with horizontal
investment because they believe that this approach enables them
to share experience, resources, and knowledge already
developed at home, thus reducing risk.
If FDI abroad is to manufacture products not
manufactured by the parent company at
home, it is called Conglomerate FDI. For example,
Hong Kong MNEs often set up foreign subsidiaries or acquire
local firms in mainland China to manufacture goods that are
unrelated to the parent company's product portfolio.
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8. Types of FDI
Vertical FDI occurs when the MNE enters a foreign
country to produce intermediate goods that are
intended for use as inputs in its home country (or in
other subsidiaries) production process (this is called
"backward vertical FDI"), or to market its
homemade products overseas or produce final
outputs in a host country using its home-supplied
intermediate goods or materials (this is called
"forward vertical FDI"). An example of backward
vertical FDI is offshore extractive investments in
petroleum and minerals. An example of forward vertical
integration is the establishment of an assembly plant or a
sales branch overseas….
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9. Entry Mode
The manner in which a firm chooses to enter a
foreign market through FDI is referred to as entry
mode. Entry mode examples include
international franchising, branches, contractual
alliances, equity joint ventures, and wholly
foreign-owned subsidiaries.
While GE (the United States) and SNECMA (France) decided to form a
joint venture to produce civilian jet engines, Mercedes-Benz (Germany)
chose to establish a wholly owned subsidiary in Alabama to
manufacture sports utility vehicles.
Once the entry mode is selected, firms determine the specific approach they
will use to establish or realize the chosen entry mode. Specific investment
approaches include (a) Greenfield investment (i.e., building a
brand-new facility), (b) cross-border mergers, (c) cross-border
acquisitions, and (d) sharing or utilizing existing facilities.
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10. The Strategic Logic behind
FDI
Different MNEs might have different strategic logic
underlying FDI.
Resource-seeking FDI attempts to acquire
particular resources at a lower real cost than could
be obtained in the home country.
Resource-seekers can be further
classified into 3 groups: those seeking physical
resources; those seeking abundant supplies of
cheap and/or skilled labor; and those seeking
technological, organizational, and managerial
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11. The Strategic Logic behind FDI
Market-seeking FDI attempts to secure market
share and sales growth in the target foreign
market. Apart from market size and the prospects for
market growth, the reasons for market-seeking FDI
include (1) the firm's main competitors, suppliers or
customers have set up foreign producing facilities abroad
and the firm needs to follow them overseas; and
(2) the firm may consider it necessary, as part of its
global production and marketing strategy, to maintain a
physical presence in the leading
markets …
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12. Efficiency-seeking FDI attempts to
rationalize the structure of established
resource-based or marketing-seeking
investment in such a way that the firm can gain
from the common governance of geographically
isolated activities. MNEs with this motive generally
aim to take advantage of different factor cultures,
economic systems and policies, and market
structures by concentrating production in a limited
number of locations to supply multiple markets.
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13. Finally, Strategic asset-seeking FDI
attempts to acquire the assets of foreign firms so
as to promote their long-term strategic
objectives, especially advancing their international
competitiveness. Procter & Gamble, for instance, has
sales in over 140 countries and on the ground
operations in over 70 countries. Its strategic
aims behind product and geographical
diversifications include better resources,
larger markets, and higher efficiency.
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14. HOW MNEs BENEFIT FROM
FOREIGN DIRECT INVESTMENT
Enhancing Efficiency from Location Advantages
FDI is potentially a better vehicle than trade for firms in terms of leveraging
factor endowment differences between home and host countries. This
is because through FDI the firm owns and controls actual
operations overseas, and can consequently capture the entire profit
margin that otherwise must be shared between an importer
and an exporter. Firms are prompted to invest abroad to
acquire particular and specific resources at lower real costs
than could be obtained in their home country. The motivation for
FDI is to make the investing firm more profitable and competitive in
the markets.. Generally, MNEs use cost-leadership strategies will choose the
location that minimizes total costs. Labor -cost, transportation costs,
tariff and non-tariff barriers, as well as governmental policies (e.g., taxes)
are important determinants of location choice.
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15. Improving Performance from
Structural Discrepancies. ( Electricity
in Pak)
Structural discrepancies are the differences in industry
structure attributes (e.g., profitability, growth
potential, and competition) between home and
host countries. Through FDI, MNEs are likely to achieve
higher performance than firms operating domestically
because they benefit from such structural discrepancies by
investing those distinct resources that can enhance
competitive advantages vis-a-vis their rivals in indigenous
markets. For example Compaq undertook FDI in the
Middle East, Latin America, and Europe partially because
the overseas competition in the computer industry is less
intense than that in the USA. Moreover, Compaq's
technological capabilities create a strong competitive position
for the firm in these markets….
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16. Increasing Return from Ownership
Advantages
Ownership advantages are benefits derived from the proprietary
knowledge, resources, or assets possessed only by the owner
(the MNE) and possession of intangible assets (e.g.,
reputation, brand image, and unique distribution channels) or
proprietary knowledge (e.g., technological expertise,
organizational skills, and international experience) confers on
their foreign owners’ competitive advantages. FDI is hence a way
of further exploiting the value-creation potential of skills and
product offerings by applying them to new markets. IBM, for
example, generates significant income from its voice recognition
software used by many Chinese. This software, first
developed in the United States, did not generate sizable income
until a Chinese version was developed by the company's
subsidiary in Beijing.
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17. Ensuring Growth from
Organizational Learning
Organizational learning has long been a key building block and
major source of competitive advantages. Sustainable
competitive advantages are only possible when
firms continuously re-invest in building new
resources or upgrading existing resources.
FDI provides learning opportunities through
exposure to new markets, new practices, new
ideas, new cultures, and even new
competition.. For example, many early movers entering
China such as Motorola, Kodak, Philips, Sony, realize that
the relationship-building skills they learned in China apply in
their business in Russia, Southeast Asia and Latin America,
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18. Foreign Direct Investment
Theories
There are several theories that explain why MNEs use
FDI: international product life cycle, market
internalization, eclectic theory, and market power.
These are explained below.
International product life-cycle theory.
The concept of international product life cycle helps
to explain both international trade and FDI.
• The theory of the international product life cycle is
that a company will begin marketing a
product through exports and later use FDI
as a product moves through its life cycle.
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19. • The international product life-cycle theory is limited in
its power to explain why companies prefer FDI
over other forms of selling overseas. A local firm in
the target market could apply and pay for a license to
use the special knowledge and assets needed to
manufacture a particular product. This way, a company
could avoid the additional risks associated with FDI
in the target market. The theory also fails to explain why
firms choose FDI over exporting activities. It
might be less expensive to serve a market abroad by
increasing output at the home-country factory rather
than by building additional capacity in the target market.
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20. Market imperfections theory
OR Internalization theory
Market imperfections theory states that
when an imperfection in the market
makes a transaction less efficient than
it could be, a company will undertake
FDI to internalize the transaction and
thereby remove the imperfection.
There are 2 market imperfections that are
relevant to this theory: Trade barriers
and specialized knowledge.
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21. Trade barriers
A common market imperfection in international
business is trade barriers such as tariffs.
Consequently, a large number of foreign
manufacturers are opening facilities in Mexico or
Canada and thereby enjoying the advantages of
exporting within the North American Free Trade
Agreement (NAFTA) region. In this way, the MNEs
are able to avoid the North American tariffs that
would have been levied if they were to export
products from their home-based factories. In other
words, the presence of a market imperfection,
namely tariffs, caused MNEs to undertake FDI.
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22. Specialized knowledge
At times, companies need an access to
specialized knowledge that happens to
be overseas, in a foreign country. One
way to acquire this knowledge is to
acquire the rights for a limited time
or for a particular product. However, if
this specialized knowledge is embedded
in its employees, the best way to
acquire it is through FDI.
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23. (Why Choose FDI?)
1. Exporting - producing goods at home and then shipping
them to the receiving country for sale
• exports can be limited by transportation costs and trade barriers
• FDI may be a response to actual or threatened trade barriers such as
import tariffs or quotas
1. 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
• Internalization theory ( market imperfections theory)
suggests that licensing has three major drawbacks compared
to FDI
• firm could give away valuable technological know-how to
a potential foreign competitor
• does not give a firm the control over manufacturing,
marketing, and strategy in the foreign country
• the firm’s competitive advantage may be based on its
management, marketing, and manufacturing capabilities..
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24. Eclectic theory
The eclectic theory states that MNEs undertake FDI
when the features of a particular location combine
with ownership and vertical integration
advantages to make a location appealing for FDI.
The advantages of locating a particular business
activity in a specific location may be natural
resources, such as oil or coal, but they may also be
an educated skillful workforce, brand
recognition, technical knowledge, or
management ability.. The eclectic theory states
that when all of the advantages are present in one form
or another an MNE will undertake FDI.
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25. Market power or dominance
theory
The market or dominance power theory states that a firm
tries to establish a dominant market presence in an
industry by undertaking FDI. In this way, the firm is far better
able to dictate the cost of its inputs and/or the price
of its output. As vertical integration — the extension of
company activities into stages of production that provide a
firm's inputs or absorb its output — helps the company to
achieve market dominance. This backward or forward
integration may be done through FDI in target countries.
Companies may also achieve market dominance by
making investments in distribution channels in foreign
markets in order to compete effectively with local or locally
based corporations.
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26. Growth of Foreign Direct
Investment
Foreign direct investment continues to expand
rapidly. Despite the global economic crisis and the
global economic slowdown of 2008 and 2009, FDI
reached over $1.5 trillion.
• The main reasons for the growth of FDI during the
first decade of the 21st century are
• 1 Globalization.
• 2 Strategic alliances (SA) and mergers and
acquisitions (M&A).
• The value of FDI has grown in a very significant
way between the years 2000 and 2007.
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27. 7-27

28. Foreign Direct Investment in the
World
(What Are The Patterns Of FDI?)Both the flow and stock of FDI have increased over the last
30 years
• Most FDI is targeted towards developed nations - United States and
EU
• South, East, and South East Asia - China – and Latin America are emerging
• FDI has grown more rapidly than world trade and world
output
• firms still fear the threat of protectionism.
• changes in the economic and political policies of many countries have
opened new markets to investment which encouraged FDI.
• globalization is forcing firms to maintain a presence around the world.
• Gross fixed capital formation - the total amount of capital
invested in factories, stores, office buildings…..
• the greater the capital investment in an economy, the more favorable
its future prospects are likely to be !!!
So, FDI is an important source of capital investment
and a determinant of the future growth rate of an
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29. Trends in FDI
FDI Outflows 1982-2008 ($ billions)
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30. 7-30
Global FDI

31. The Direction of FDI
FDI Inflows by Region 1995-2008 ($ billion)
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32. Inward FDI as a % of Gross Fixed Capital Formation
1992-2007
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33. What Is The Source Of FDI?
• Since World War II, the U.S. has been the largest
source country for FDI
• the United Kingdom, the Netherlands, France,
Germany, and Japan are other important
source countries
• together, these countries account for 56% of
all FDI outflows from 1998-2006, and 61% of
the total global stock of FDI in 2007
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34. Cumulative FDI Outflows 1998-2007 ($ billions)
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35. 7-35
What Merger and acquisitions
(M&A)
Definition of 'Mergers And Acquisitions - M&A'
A general term used to refer to the consolidation of companies. A
merger is a combination of two companies to form a new
company, while an acquisition is the purchase of one
company by another in which no new company is
formed.
E Commerce…..
Electronic commerce, commonly known as e-commerce, is a type of industry
where buying and selling of product or service is
conducted over electronic systems such as the
Internet and other computer networks.
Modern electronic commerce typically uses the World Wide Web at least at one
point in the transaction's life-cycle, although it may encompass a wider range of
technologies such as e-mail, mobile devices social media, and telephones as
well.

36. 7-36

37. Why Do Firms Choose Acquisition
Versus Greenfield Investments?
• Most cross-border investment is in the form of
mergers and acquisitions rather than greenfield
investments
• Firms prefer to acquire existing assets because
• mergers and acquisitions are quicker to execute than
greenfield investments
• it is easier and perhaps less risky for a firm to acquire
desired assets than build them from the ground up
• firms believe that they can increase the efficiency of an
acquired unit by transferring capital,
technology, or management skills….
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38. Why Does FDI In Services
Occur?
• FDI is shifting away from extractive industries and
manufacturing, and towards services
• There are 4 main reasons for shift to services !!!
• the general move in many developed countries
toward services.. ( Manufacturing to retailing … From
China to EU) Shoe Manufacturing $ 8 to sold EU retail $
50) $42 only due to service the fact that many services
need to be produced where they are consumed
• a liberalization of policies governing FDI in services
• the rise of Internet-based global
telecommunications networks.. E. Commerce……
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39. 1-39

40. 1-40

41. 41
Nike Creates ValueNike Creates Value
(Exploitation of cheap labor in developing(Exploitation of cheap labor in developing
countries to maximize their stockholders profitscountries to maximize their stockholders profits
in the west)in the west)

42. 42
ADIDAS pays 8 Euro/shoe (manufacturing outsourcing in China)ADIDAS pays 8 Euro/shoe (manufacturing outsourcing in China)
and sells for 100 Euro in Europe & the US…and sells for 100 Euro in Europe & the US…
Low
High

43. 43
Position of ChinaPosition of China ’’s industry on the smile curves industry on the smile curve
Chinese
case

44. Benefits and Costs of FDI
How Does FDI Benefit The Host Country?
• There are four main benefits of inward FDI for a host
country
1. Resource transfer effects - FDI brings capital,
technology, and management resources
2. Employment effects - FDI can bring jobs
3. Balance of payments effects - FDI can help a country
to achieve a current account surplus
4. Effects on competition and economic growth -
greenfield investments increase the level of
competition in a market, driving down prices and
improving the welfare of consumers
• can lead to increased productivity growth, product and
process innovation, and greater economic growth
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45. What Are The Costs Of
FDI To The Host Country?
Inward FDI has three main costs:
1. Adverse effects of FDI on competition within the host nation
• subsidiaries of foreign MNEs may have greater economic
power than indigenous competitors because they may be
part of a larger international organization
1. Adverse effects on the balance of payments…
• 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
1. Perceived loss of national sovereignty and autonomy…
• decisions that affect the host country 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
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46. How Does FDI Benefit
The Home Country?
• The benefits of FDI for 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 ,I.e. that Nissan USA imports a lot of inputs
from Japan creating jobs there.
3. The gains from learning valuable skills from
foreign markets that can subsequently be
transferred back to the home country 7-46

47. What Are The Costs Of
FDI To The Home Country?
1. The home country’s balance of payments can suffer
• from the initial capital outflow required to finance the
FDI
• if the purpose of the FDI is to serve the home market
from a low cost production location
• if the FDI is a substitute for direct exports
1. Employment may also be negatively affected if the
FDI is a substitute for domestic production
But, international trade theory suggests that home
country concerns about the negative economic
effects of offshore production (FDI undertaken
to serve the home market) may not be valid
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48. How Does Government
Influence FDI?
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.
• Governments can encourage outward FDI
• government-backed insurance programs to cover major
types of foreign investment risk, Special loan programs,
Creates tax incentives.
• Governments can restrict outward FDI
• limit capital outflows, manipulate tax rules ( Use tax
incentives to keep investment at home), or outright prohibit
FDI like USA has done for companies invest in Iran .
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49. How Does Government
Influence FDI?
• Governments can encourage inward FDI
• offer incentives to foreign firms to invest in their countries
• gain from the resource-transfer and employment effects of FDI, and
capture FDI away from other potential host countries
• Governments can restrict inward FDI
• use ownership restraints and performance requirements
• In Sweden for example, foreign companies aren’t allowed to
invest in the tobacco industry.
Because they keep foreign firms out of certain industries on the
grounds of national security or competition, allowing the local
firms to develop.
• 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.
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50. How Do International
Institutions Influence FDI?
• Until the 1990s, there was no consistent
involvement by multinational institutions
in the governing of FDI
• Today, the World Trade Organization is
changing this by trying to establish a
universal set of rules designed to promote
the liberalization of FDI
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