CH 7

Foreign Direct Investment

 Importance of FDI in world economy

 Theories used to explain FDI
 Government policy towards FDI
FDI Terms
 FDI = firm invests directly in facilities to
produce and/or market a product in a foreign
country
 Green-field investment = establishment of a new
operation
 Acquiring or merging with an existing firm

 Multinational Enterprise = firm that owns

business operations in more than one country
FDI Terms
 Flow of FDI = amount of foreign direct
investment undertake over given period
 FDI outflows = FDI flow out of a country
 FDI inflows = FDI flow into a country

 Stock of FDI = total accumulated value

of foreign owned assets at a given time
Growth of FDI
 Firms fear protectionist pressures

 Way of circumventing future trade barriers

 Political and economic changes – shift toward

democratic political institutions and free
market economies

 Globalization of the world economy

Drivers of FDI
 To get access to national markets

 Establish low cost manufacturing

locations from which to serve regional
or global markets

 Important to have production facilities

based close to their major customers
Direction of FDI
 Historically directed at the developed
nations
 US was largest recipient because
 Large and wealthy domestic market
 Stable economy
 Favorable political environment
 Openness to FDI
Direction of FDI
 Recent inflow targeted into developing
nations – emerging economies
 Asia, especially China
 Latin America

 Inability of Africa to attract FDI

 Political unrest, armed conflict
 Frequent changes in economic policy
Source of FDI
 60% of all FDI outflows 1997-2002
 US has been the largest source country
 UK, Netherlands, France, Germany, Japan

 2002 – 100 largest multinationals

 26% US
 17% Japanese
 12% French
 12% German
 10% British
Form of FDI
 Majority of cross-border investments in the form of
mergers & acquisitions rather than green-field
 Developed nations 2/3 M&A
 Developing nations 1/3 M&A

 Why M&A
 Quicker and easier to execute than Green-field
 Acquire valuable strategic assets – brand loyalty, customer
relations, trademarks & patents, distribution systems,
production systems, etc.
 Increase efficiency of acquired unit by transferring capital,
technology or management skills
Theories of FDI
 Why FDI when could export or license

 Why firms in same industry undertake

FDI at same time & why certain
locations are favored as targets

 Eclectic paradigm – combine the two

Alternative to FDI
 Exporting
 Producing good at home and shipping to receiving
country for sale

 Limitations- viability is often

constrained by
 transportation costs – unprofitable to ship some
products over large distances
 trade barriers – import tariffs or quotas
Alternative to FDI
 Licensing
 Granting a foreign licensee the right to produce & sell the
firm’s products in return for a royalty fee on every unit

 Limitations – Internalization theory

 Give away valuable technological know-how to potential
foreign competitor
 Lack of control over manufacturing, marketing & strategy
required to maximize profitability
 Firm’s competitive advantage may be based not on product,
but on marketing, management or manufacturing process
capabilities
FDI
best entry strategy when
 Firm has valuable know-how that cannot be
adequately protected by a licensing contract

 Firm needs tight control over a foreign entity

to maximize its market share and earnings in
that country

 Firm’s skills and know-how are not amenable

to licensing
Pattern of FDI
 Knickerbocker - Mulitpoint competition
 Firms in the same industry often undertake FDI at
same time
 Clear tendency to direct FDI toward certain locations

 Reflection of strategic rivalry of competitors

 Oligopoly – interdependence of major players
 Firms tend to imitate each other’s FDI
 Match each other’s moves to hold each other in check
Pattern of FDI
 Raymond Vernon - Product Life cycle
 Firms undertake FDI at particular stages in the life
cycle of a product that they have pioneered in
their home market
 Invest in other countries when local demand is
large enough to support local production
 Shift production to developing countries when
product standardization and market saturation
give rise to price competition and cost pressure.
Eclectic Paradigm
 British economist John Dunning

 In addition to theories of patterns of trade

-Location specific advantages important in
explaining rationale for and direction of FDI
 Combining location specific assets or resource
endowments & the firm’s own unique
technological or management capabilities
often requires FDI
Political Ideology & FDI
 Radical view - MNE is instrument of
imperialist domination
 Exploit host country for benefit of home country
 Keeps developing countries backward &
dependent on capitalist nations for investment,
jobs & technology
 Extract profits & give nothing of value to host
country
 Important jobs go to home country nationals
Political Ideology & FDI
 Free Market View – Adam Smith & David
Ricardo

 Theory of comparative advantage

 Countries should specialize in the production of
those goods & services they can produce most
efficiently
 MNE is instrument for dispersing production to the
most efficient locations around the globe
 FDI resource transfers benefit the host country &
stimulate its economic growth
Political Ideology & FDI
 Pragmatic Nationalism – FDI has both
benefits & costs

 Benefit a host country with capital, skills,

technology, & jobs
 Costs to host country in terms of repatriation of
profits and importing of components
 FDI should be allowed if the benefits outweigh the
costs
FDI Benefits
Host Country
 Resource transfer effects
 Supplying capital, technology & management resources

 Employment effects
 Brings jobs directly by MNE employing & indirectly by suppliers employing
 MNE tend to pay higher wages

 Balance of payment effects

 Tracks payments to & receipts from other countries
 FDI can substitute for imports, & can export to other countries

 Effects on competition & economic growth

 Green-field increases the number of players, increase competition
 Competition drive down prices & benefit consumers
 Increased productivity, innovation & economic growth
FDI Costs
Host Country
 Adverse effects on competition
 MNE subsidiaries may have greater economic power than
indigenous firms

 Adverse effects on balance of payments

 Too much outflow so restrict the amount that can be
repatriated
 Too much importing of components vs local sourcing

 Perceived loss of national sovereignty

 Key decisions that effect host economy will be made by
foreign parent with no commitment to & no control by host
country
FDI Benefits
Home Country
 Inward flow of foreign earnings
 May also create demand for home country exports
of equipment & goods

 Employment effects
 Jobs created by demand for exports

 MNE learns valuable skills that can be

transferred back
 reverse resource-transfer contributing to home
country economic growth rate
FDI Costs
Home Country
 Balance of payments
 Suffers from initial capital outflow to finance FDI
 Suffers if purpose to supply home market from
low-cost production location
 Suffers if the FDI is substitute for direct exports

 Employment effects
 Suffers when FDI is substitute for domestic
production – reduced home country employment
FDI & Government Policy
Home Country
Policies for encouraging outward FDI

 Foreign risk insurance

 Risks of expropriation (nationalization)
 War losses
 Inability to transfer profits back home

 Capital assistance
 Special funds or banks to make government loans to encourage domestic firms to
undertake FDI

 Tax incentives
 Eliminate double taxation of foreign income (host & home governments)

 Political pressure
 Use political influence to encourage host countries to reduce FDI restrictions
FDI & Government Policy
Home Country
Restricting Outward FDI

 Limit capital outflows out of concern for the balance

of payments

 Manipulated tax rules to encourage their firms to

invest at home – create jobs at home

 Countries sometimes prohibit national firms from

investing in certain countries for political reasons.
(Cuba, South Africa)
FDI & Government Policy
Host Country
Encouraging inward FDI

 Offer incentives for foreign firms to invest in their countries

 Tax concessions
 Low-interest loans
 New state spending on infrastructure
 Grants or subsidies

 Desire to gain from the resource transfer and employment

effects

 Desire to capture FDI away from other potential host countries

FDI & Government Policy
Host Country
Restricting inward FDI
 Ownership restraints
 Foreign companies excluded from specific fields – national
security or competition (infant industry)
 Significant proportion of the equity of the subsidiary must
be owned by local investors – maximize resource-transfer &
employment benefits

 Performance requirements
 Maximize the benefits and minimize the costs
 Related to local content, exports, technology transfer &
local participation by top management
International Institutions &
FDI
WTO
 Embraces the promotion of trade in services

 Many services need to be produced where

they are sold

 Push for the liberalization of FDI particularly

in services
 Less successful in establishing universal rules

with regards to FDI

Managerial Implications
 Relative profitability of FDI, exporting & licensing
vary with circumstances

 As transport costs & trade barriers increase, FDI or

licensing are better

 Licensing not best when have valuable know-how or

need tight control

 Host governments attitude toward FDI important

variable in where to locate production