3 FDI

Chapter 3 Foreign Direct Investment (FDI)

Learning objectives

1.Be familiar with current trends regarding FDI in the world economy.

2.Understand different theories of foreign direct investment.

3.Understand the benefits and costs of FDI to home and host countries.

4.Articulate the implications for management practice associated with FDI.

1 Introduction

Foreign direct investment occurs when a firm invests directly in facilities to produce or market a product in a foreign country. According to the U.S. Department of Commerce, FDI occurs whenever a U.S. citizen, organization, or affiliated group takes an interest of 10% or more in a foreign business entity. Once a firm undertakes FDI, it becomes a multinational enterprise.

FDI takes on two main forms: The first is a Greenfield investment, which involves the establishment of a new operation in a foreign country. The second involves acquiring or merging with an existing firm in the foreign country. Acquisitions can be as a majority (where the foreign firm takes 10% to 49% interest in the firm’s voting), minortiy (foreign interest of 50% to 99% ), or foreign full outright stake(foreign interest of 100%).

We begin this chapter by looking at the importance of FDI in the world economy. Next, we review the theories that have been used to explain FDI. The chapter then moves on to look at government policy toward FDI and closes with a section on implications for business.

2 Foreign Direct Investment in the World Economy

When discussing FDI, it is important to distinguish between the flow of FDI and the stock of FDI. The flow of FDI refers to the amount of FDI under taken over a given time period (normally a year). The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. When we talk about Outflows of FDI, meaning the flow of FDI out of a country, and inflows of FDI, the flow of FDI into a country.

2.1 Trends in FDI

The past 30 years have seen a marked increase in both the flow and stock of FDI in the world economy. The average yearly outflow of FDI increased from $25billion in 1975 to a record $1.2 trillion. It fell back in the early 2000s, but by 2006 FDI flows were again around $ 1.2 trillion. Over this period, the flow of FDI accelerated faster than the growth in world trade and world output.

FDI has grown more rapidly than world trade and world output for several reasons.

First, despite the general decline in trade barriers over the past 30years, business firms still fear protectionist pressures. Executives see FDI as a way of circumventing future trade barriers. Second, much of the recent increase in FDI is being driven by the political and economic changes that have been occurring in many of the world’s developing nations. The globalization of the world economy is also having a positive impact on the volume of FDI.

2.2 The Direction of FDI

Historically, most FDI has been directed at the developed nations of the world as firms based in advanced countries invested in the others’ markets. During the 1980s and 1990s, the United States was often the favorite target for FDI inflows for its large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI.

Even though developed nations still account for the largest share of FDI inflows, FDI into developing nations has increased. Most recent inflows into developing nations have been targeted at the emerging economies of South, East, and Southeast Asia. Driving much of the increase has been the growing importance of China as a recipient of FDI.

Latin America emerged as the next important region in the developing world for FDI inflows.

2.3 The source of FDI

Since world war, the United States has been the largest source country for FDI, a position it retained during the late 1990s and early 2000s. Other important source countries include the United Kingdom, France, Germany, the Netherlands, and Japan. Collectively, these six countries accounted for 57% of all FDI outflows for the 1998-2005 period and 61% of the total global stock of FDI in 2006.

2.4 The form of FDI: Acquisition versus Greenfields investment

FDI can take the form of a Greenfield investment in a new facility or an acquisition of or a merger with an existing local firm. The data suggest the majority of cross-border investment is in the form of mergers and acquisitions rather than Greenfield investment.

When contemplating FDI, why do firms apparently prefer to acquire existing assets rather than undertake Greenfield investments? First, mergers and acquisitions are quicker to execute than Greenfield investments. Second, foreign firms are acquired because those firms have valuable strategic assets. Third, firms make acquisitions because they believe they can increase the efficiency of the acquired unit by transferring capital, technology, or management skills.

2.5 The shift to service: FDI of transnational banks

In the past 30 years, the sector composition of FDI has shifted sharply away from extractive industries and manufacturing and toward services. In 1990, some 47% of FDI stock was in service industries; by 2004, the figure had increased to 66%. Similar trends can be seen in the composition of cross-border mergers and acquisitions, in which services are playing a much larger role.

The shift to services is being driven by four factors that will probably continue to be important for some time. First, the shift reflects the general move in many developed economies away from manufacturing and toward service industries. Second, many services can’t be traded internationally. Finally, the rise of internet-based global telecommunications networks has allowed some service enterprises to relocate some of their value-creation activities to different nations to take advantage of favorable factor costs.

3 Theories of Foreign Direct Investment

In this section, we review several theories of FDI. These theories approach the various phenomena of FDI from three complementary perspectives.

3.1 Why FDI occurs?

3.1.1 Limitations of FDI

The viability of an exporting strategy is often constrained by transportation costs and trade barriers. When transportation costs are added to production costs, it becomes unprofitable to ship some products over a large distance. Transportation costs aside, some firms undertake foreign FDI as a response to actual or threatened trade barriers such as import tariff and quotas. B y placing tariffs on imported goods, governments can increase the cost of exporting relative to FDI and licensing..

3.1.2 Limitations of Licensing

A branch of economic theory known as internalization theory seeks to explain why firms often prefer FDI over licensing as a strategy for entering foreign markets(this approach is also known as the market imperfections approach).According to internalization theory, limitations of Licensing are as below:

First, licensing may r esult in a firm’s giving away valuable technological know-how to a potential foreign competitor. A second problem is that licensing 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.

A third problem with licensing arises when the firms competitive advantage is based not as much on its products as on the management, marketing, and manufacturing capabilities that produce those products. The problem is that such abilities are often not amendable to licensing.

3.2 The pattern of FDI

3.2.1 Strategic behavior

In 1973, Knicker bocker published the book of "reaction and multinational monopoly," further developed the Bruckheimer –Kind leberger's "monopoly advantages theory." Through his analysis investment behaviors of 187 U.S. multinational companies, found that foreign direct investment depended largely on the behaviors, constraints and responses between competitors in some oligopolistic industry,. Knicker bocker's theory was based on the analysis of industry structure and market structure, market structure were divided into three categories: (1) a perfectly competitive market; (2) tension-type oligopoly markets; (3) Loose oligopoly.

3.2.2 The product life cycle

Raymond Vernon’s product life-cycle theory also can be used to explain FDI. Vernon’s view is that firms undertake FDI at particular stages in the life cycle of a product they have pioneered. They invest in other advanced countries when local demand in those countries grows large enough to support local production. They subsequently shift production to developing countries when product standardization and market saturation give rise to price competition and cost pressures. Investment in developing countries, where labor costs are lower, is seen as the best way to reduce costs.

3.3 The Eclectic Paradigm

British economist John Dunning has championed the eclectic paradigm Dunning argues that in addition to the various factors discussed above, location-specific advantages are also of considerable importance in explaining both the rational for and the direction of FDI. Dunning means the location-specific advantages that arise from utilizing resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets.

4 Benefits and Costs of FDI

4.1 Host-country benefits

The main benefits of inward FDI for a host country arise from resource-transfer effects, employment effects, and balance-of-payments effects.

4.1.1 Resource-Transfer Effects

FDI can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available and thus boost that country’s economic growth rate.

With regard to capital, many MNEs by virtue of their large size and financial strength have access to financial resources not available to host-country firms. These funds may be available from internal company resources, or because of their reputation, large MNEs may find it easier to borrow money from capital markets than host-country firms would.

4.1.2 Employment Effects

Another beneficial employment effect claimed for FDI is that it brings jobs to a host country that would otherwise not be created there. The effects of FDI on employment are both direct and indirect. Direct effects arise when a foreign MNE employs a

number of host-country citizens. Indirect effects arise when jobs are created because of increased local spending by employees of the MNE. The indirect effects are often as large as , if not larger than the direct effects.

4.1.3 Balance-of-payments Effects

First, if the FDI is a substitute for imports of goods or services, the effect can be to improve the current account of the host country’s balance-of-payments. A second potential benefit arises when the MNE uses a foreign subsidiary to report goods and services to other countries.

4.2 Host-country costs

These costs of FDI concern host countries. They arise from possible adverse effects on competition within the host nation, adverse effects on the balance of payments, and the perceived loss of national sovereignty and autonomy.

4.2.1 Adverse effects on competition

Once the market is monopolized, the foreign MNE could raise prices above those that would prevail in competitive markets, with harmful effects on the economic welfare of the host nation.

4.2.2 Adverse effects on balance-of-payments

The possible adverse effects of FDI on a host country’s balance-of-payments position are twofold.

First, the initial capital inflow that comes with FDI must be set against the subsequent outflow of earnings from the foreign subsidiary to its parent company.

A second concern arises when a foreign subsidiary imports a substantial number of its inputs from abroad, which results in a debt on the current account of the host country’s home country.

4.2.3 National sovereignty and autonomy

Some host countries worry about FDI is accompanied by some loss of economic independence. The concern is that 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.

4.3 Home-country benefits

The benefits of FDI to the home country arise from three sources. First, the home country’s balance of payments benefits from the inward flow of foreign earnings. Second, benefits to the home country from outward FDI arise from employment effects. As with the balance of payments, positive employment effects arise when the foreign subsidiary creates demand for home-country exports.

Third, benefits arise when the home-country MNE learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home country. This amounts to a reverse resource-transfer effect.

4.4 Home-country costs

Against these benefits must be set the apparent costs of FDI for the home country. The most important concerns center on the balance-of-payments and employment effects of outward FDI. First, the balance of payments suffers from the initial capital outflow required to finance the FDI. Second, the current account of the balance of payments suffers if the purpose of the foreign investment is to serve the home market from a

low-cost production location. Third, the current account of the balance of payments suffers if the FDI is a substitute for direct exports.

5 Government Policy Instrument and FDI

5.1 Home-country Policy

Through their choice of policies, home countries can both encourage and restrict FDI by local firms. We look at policies designed to encourage outward FDI first, including foreign risk insurance, tax incentives, and political pressure.

5.1.1 Encouraging outward FDI

Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk. The types of risks insurable through these programs include the risks of expropriation, war losses, and the inability to transfer profits back home. In addition to government-backed insurance programs, special funds and banks that make government loans to firms to undertake investments in developing countries

5.1.2 Restricting outward FDI

One policy has been to limit capital outflows out of concern for the country’s balance of payments. In addition, countries have occasionally manipulated tax rules to try to encourage their firms to invest at home. Finally, countries sometimes prohibit national firms from investing in certain countries for political reasons. Such restrictions can be formal or informal.

5.2 Host-country Policy

Host countries adopt policies designed both to restrict and to encourage inward FDI. 5.2.1 Encouraging inward FDI

It is common for government to offer incentives to foreign firms to invest in their countries. Such incentives take many forms, but the most common are tax concessions, low-interest loans, and grants or subsidies. Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI. They are also motivated by a desire to capture FDI away from other to attract FDI.

5.2.2 Restricting inward FDI

Host countries use a wide range of controls to restrict FDI in one way or another. The two most common are ownership restrains and performance requirements. Ownership restraints can take several forms.

The rationale underlying ownership restraints seems to be twofold. First, foreign ownership are often excluded from certain sectors on the grounds of national security or competition. Second, ownership restraints seem to be based on a belief that local owners can help maximize the resource-transfer and employment benefits of FDI for the host countries.

Performance requirements can also take several forms. Performance requirements are controls over the behavior of the MNE’s local subsidiary. The most common performance requirements are related to local content, exports, technology transfer, and local participation in top management.

5.3 Government Policy

A host government’s attitude toward FDI should be an important variabl e in decisions about where to locate foreign production facilities and where to make FDI. From the perspective of a firm negotiating the terms of an investment with a host government, the firm’s bargaining power is high when the host government places a high value on what the firm has to offer, the number of comparable alternatives open to the firm is greater, and the firm has a long time in which to complete the negotiations. To a large degree, the outcome of any negotiated agreement depends on the relative bargaining power of both parties. Each side’s bargaining power depends on three factors:

The value each side places on what the other has to offer

The number of comparable alternatives available to each side

Each party’s time horizon

Exercises

Nouns Explanation

Internalization theory

The product life cycle theory,

Asks and answers

Try to compare bellowing theory of FDI: internalization theory, the product life cycle theory, theory of FDI of Knicker bocker's theory

Research taskes

Your company is considering opening a new factory in Latin America, and management I sin the process of evaluating the specific country locations for this direct investment. The pool of candidate countries has been narrowed to Argentina, Mexico, and Brazil. Prepare a short report from a well-known organization’s publication of country Fact Sheets to compare the foreign direct investment environment and regulations of these countries.