111 Foreign Direct Investment

UNIT IV

112 International Business

LESSON

113 Foreign Direct Investment

7
FOREIGN DIRECT INVESTMENT
CONTENTS 7.0 7.1 7.2 7.3 7.4 7.5 7.6 Aims and Objectives Introduction Foreign Direct Investment in the World Economy Direction of FDI Source of FDI Form of FDI: Acquisition versus Green-field Investments Horizontal Foreign Direct Investment 7.6.1 7.6.2 7.6.3 7.6.4 7.6.5 7.7 7.7.1 7.7.2 7.8 7.9 Transportation Costs Market Imperfections Product Life Cycle Strategic Behaviour Location Advantages Strategic Behaviour Argument Market Imperfections Approach

Vertical Foreign Direct Investment

Implications of FDI for Business Benefits of FDI to Host Countries 7.9.1 7.9.2 7.9.3 7.9.4 Resource-transfer Effects Employment Effects Balance-of-payments Effect Effect on Competition and Economic Growth

7.10 Costs of FDI to Host Countries 7.10.1 Possible Adverse Effects on Competition within the Host Nation 7.10.2 Adverse Effects on the Balance of Payments 7.10.3 Perceived Loss of National Sovereignty and Autonomy 7.11 Benefits and Costs of FDI to Home Countries 7.11.1 Benefits of FDI to the Home Country 7.11.2 Costs of FDI to the Home Country 7.12 Political Risk and FDI 7.12.1 Measurement of Political Risk 7.12.2 How to Manage/Mitigate Political Risk 7.12.3 Country Risk: What is this? 7.13 Let us Sum up 7.14 Lesson End Activity 7.15 Questions for Discussion 7.16 Suggested Readings

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7.0 AIMS AND OBJECTIVES

After studying this lesson, you should be able to understand: The importance of direct investments specially when, for example, a company builds a manufacturing plant in another country How to evaluate foreign direct investments, including the discount rate and tax rate to employ

7.1 INTRODUCTION
Through Foreign Direct Investment a firm invests directly in facilities to produce and/or market a product in a foreign country. Example: In the early 1980s Honda, a Japanese automobile company, built an assembly plant in Ohio and began to produce cars for the North American market. These cars were substitutes for imports from Japan. Once a firm undertakes FDI, it becomes a Multinational Enterprise (The meaning of Multinational being more than one country). FDI takes on two main forms; the first is a green field investment, which involves the establishment of a wholly new operation in a foreign country. The second involves acquiring or merging with an existing firm in a foreign country. Acquisition can be a minority (where the foreign firm takes a 10 percent to 49 percent interest in the companys Share Capital and voting rights), or majority (foreign interest of 10 percent to 99 percent) or full outright stake (foreign interest of 100 percent). There is an important distinction between FDI and Foreign Portfolio Investment (FPI). Foreign portfolio investment is investment by individuals, firms or public bodies (e.g. National and local Govts) in foreign financial instruments, (e.g. Government bonds, foreign stocks). FDI does not involve taking a significant equity stake in a foreign business entity. FPI is determined by different facts than FDI. FPI provides great opportunities for business and individuals to build a truly diversified portfolio of international investments in financial assets, which lowers risk.

7.2 FOREIGN DIRECT INVESTMENT IN THE WORLD ECONOMY

The flow of FDI refers to the amount of FDI undertaken over a given time period (normally a year). The stock of FDI refers to the total accumulation of foreign owned assets at a given time. We also talk of outflows of FDI meaning the flow of FDI out of the country and inflows of FDI, meaning the flow of FDI into a country. The past 20 years have seen a marked increase in both the flow and stock of FDI in the world economy. The average outflow of FDI is increased from about $25 billion in 1975 to a record of $1.3 trillion in 2000. The flow of FDI not only accelerated over this last quarter, country load is also accelerated faster than the growth in world trade. For example, between 1990 and 2000, the flow of FDI for all countries increased about five fold, while world trade grew by some 82 percent and world outflow by 23 percent. As a result of strong FDI flow, by 2000 the global stock of FDI exceeded $5.7 trillion. In total, 63,000 parent companies had 6,90,000 affiliates in foreign markets that effectively produced an estimated $14 trillion in global sales, nearly twice as high as the value of global exports. FDI is growing more rapidly than world trade and world output for several reasons: 1. Fear of protectionist pressure despite the general decline in trade barriers Example: Much of the Japanese automobile companies investments in the United States during the 1980s and early 1990s were driven towards reduction of exports from Japan, thereby removing trade tensions between nations.

2. Dramatic political and economic changes that have been occurring in many of the worlds developing nations, the general shift towards democratic political institutions and for market economies has encouraged FDI Economic growth, economic deregulation, privatization programs that are open to foreign investors and removal of many restrictions on FDI have made Asia, Eastern Europe and Latin America more attractive to foreign investors. 3. Increase in the amount of bilateral investment treaties designed to protect and promote investment between two countries, has been reflected in the decrease to facilitate FDI. 4. The globalization of the world economy is also having a great impact on the volume of FDI. 5. Many firms believe, it is important to have production facilities base close to the major customers. This too is creating pressures for greater FDI.

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7.3 DIRECTION OF FDI

Developed nations in general, and the United States in particular, account for the largest share of FDI inflows, there has been some increase of FDI into the worlds developing nations. From 1985 to 1990, the annual inflow of FDI into developing nations averaged $27.4 billion, or 17.4 per cent of the total global flow. By 1997, the inflow into developing nations had risen to 4149 billion, or 37 per cent of the total. However it fell back to 19 per cent of the total in 2000. 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. In 2000, China received direct investments valued at about 440 billion, and that investment increased in 2001 as China prepared to join the World Trade Organization.

7.4 SOURCE OF FDI

Since World War II, the United States has traditionally been by far the largest source country for FDI. During the late 1970s the United States still accounted for about 47 per cent of all FDI outflows from industrialized countries, while the second place United Kingdom accounted for about 18 per cent. US firms dominated the growth of FDI in the 1960s and 70s.by 1980, 178 of the worlds largest 382 multinationals were US firms and 40 of them were British. However, during 1985-90 the United States slipped to third place behind Japan and the United Kingdom. The high level of FDI outflows from the united states has been driven by a combination of factors including a strong US economy; strong corporate profits and cash flow, which have given firms the capital to invest abroad; and a relatively strong currency, particularly since 1995.Similar factors explain the continued growth of FDI outflows from the United Kingdom during the 1990s.

7.5 FORM OF FDI: ACQUISITION VERSUS GREENFIELD INVESTMENTS

FDI can take the form of a green-field investment in a new facility or an acquisition of or merger with an existing local firm. UN estimates indicate that in 1999 some 80 per cent of all FDI inflows were in the form of mergers and acquisitions. There is a marked difference, however between FDI flows into developed and developing nations. Between 1987 and 1999, the value of cross-border mergers and acquisitions into developed countries grew at 20 per cent annually and was never less than 77 per cent of all FDI flows into developed countries. In the case of developing nations, the ratio of the value of cross-border mergers and acquisitions to FDI was

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about 33 per cent in 1999, although this represented an increase from about 10 per cent a decade earlier. The lower percentage of FDI inflows in the form of mergers and acquisitions may simply reflect the fact that there are fewer target firms to acquire in developing nations. Firms prefer to acquire-existing assets rather than undertake green-field investments because of the following: First, mergers and acquisitions are quicker to execute than green-field investments. This is an important consideration. In the modern business world markets evolve very rapidly. Second, foreign firms are acquired because those firms have valuable strategic assets, such as brand loyalty, customer relationships, trademarks or patents, distribution systems, production systems, and the like. It is easier and perhaps less risky for a firm to acquire those assets than to build them from the ground up through green-field investment. Third, firms make acquisitions because they believe they can increase the efficiency of the acquired unit by transferring capital, technology, or management skills.

7.6 HORIZONTAL FOREIGN DIRECT INVESTMENT

Horizontal FDI is the investment in the same industry abroad as the firm operates at home. Other things being equal, FDI is expensive because the firm must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign enterprise. FDI is risky because of the problems associated with doing business in another culture where the rules of the game may be very different. When a firm exports, it need not bear the costs of FDI, and the risks associated with selling abroad can be reduced by using a native sales agent. Similarly, when a firm licenses its knowhow, it need not bear the costs or risks of FDI. Firms prefer FDI over either exporting or licensing because of the following factors that alter the relative attractiveness of exporting, licensing, and FDI- (i) Transportation costs (ii) Market imperfections (iii) Following competitors (iv) Strategic behaviour and (v) location advantages.

7.6.1 Transportation Costs

When transportation costs are added to production costs, it becomes unprofitable to ship some products a long distance specially products that have a low value-to weight ratio and can be produced in almost any location (e.g. cement, soft drinks etc). For such products, relative to either FDI or licensing, the attractiveness of exporting decreases. Thus transportation costs alone can explain why Cemex, the largest cement manufacturer of Mexico has undertaken FDI rather than exporting. For products with a high value-to weight ratio, transport costs are normally a very minor component of total landed cost (e.g. electronic components, personal computers, medical equipment, computer software etc.). In such cases, transportation costs have little impact on the relative attractiveness of exporting, licensing, and FDI.

7.6.2 Market Imperfections

Market imperfections are factors that restrain markets from working perfectly. In the international business literature, the marketing imperfection approach to FDI is typically referred to as Internationalization theory. With reference to horizontal FDI, market imperfections arise in two circumstances: when there are impediments to the sale of know-how (licensing is a mechanism for selling know-how). Impediments to the free-flow of products between nations decrease the probability of exporting, relative to FDI and licensing. Impediments to the sale of know-how increase the profitability of FDI relative to licensing. Thus, the market imperfections explanation

predicts that FDI will be preferred whenever there are impediments that make both exporting and the sale of know how difficult and/or expensive. Impediments to Exporting: Governments are the main source of impediments to the free flow of products between nations. By placing tariffs on imported goods, government increases the cost of exporting relative to FDI and licensing. Similarly, by limiting imports through the imposition of quotas, governments increase the attractiveness of FDI and licensing. For example, the flow of FDI by Japanese auto companies in the United States during the 1980s was partly driven by protectionists threats from Congress and by quotas on the import of Japanese cars. For Japanese auto companies, these factors have decreased the profitability of exporting and increased the profitability of FDI. Impediments to sale of know-how: According to economic theory, there are three reasons that the market does no always work well as a mechanism for selling knowhow, or why licensing is not attractive as it initially appears. First, licensing may result in a firms giving away its know-how to a potential foreign competitor. Second, licensing does not give a firm tight control over production, marketing, and in a foreign country that may be required to profitably exploit its advantage in knowhow. With licensing, control over production, marketing and strategy is granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions. For example, a firm might want its foreign subsidiary to price and market very aggressively, but the licensee may be unable to do this. Third, a firms know-how may not be amenable to licensing. This is particularly true of management and marketing know-how, where the kinds of skills required are difficult to codify and cannot be written down in a simple licensing contract. They are organization wide and have been developed over years. They are not embodied in any one individual, but instead are widely dispersed throughout the company.

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7.6.3 Product Life Cycle

The product life cycle holds that every product or line of business proceeds through four phases: development, growth, maturity and decline. During the first two stages, sales growth is rapid and entry is easy. As individual firms gain experience and as growth slows in the last two stages, entry becomes difficult because of cost advantages of incumbents. In the decline phase of the product line (as other product substitutes emerge) sales and prices decline, firms which have not achieved a favourable position on the experience curve become unprofitable and either merge or exit from the industry.

7.6.4 Strategic Behaviour

Another theory to explain FDI is based on the idea that FDI flows are a reflection of strategic rivalry between firms in the global market place. An early variant of this argument was expounded by F. T. Knickerbocker, who looked at the relationship between FDI and rivalry in oligopolistic industries. An oligopoly is an industry composed of a limited number of large firms (e.g. an industry in which four firms control 80 per cent of a domestic market may be defined as an oligopoly). A critical competitive feature of such industries is interdependence of the major players. What one firm does can have an immediate impact on the major competitors, forcing a response in kind. Knickerbockers theory can be extended to embrace the concept of multipoint competition. Multipoint competition arises when two or more enterprises encounter each others moves in different markets to try to hold each other in check. The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidize competitive attacks in other markets. Kodak

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and Fuji Photo Film Co, for example compete against each other around the world. If Kodak enters a particular foreign market, Fuji will not be far behind

7.6.5 Location Advantages

The British economist John Dunning has argued that location specific advantage can help explain the nature and direction of FDI. By location-specific advantages, Dunning means the advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds value to combine with its own unique assets (such as the firms technological, marketing, or management know-how). Dunning accepts the internalization argument that market failures make it difficult for a firm to license its own unique assets (know-how). Therefore he argues that combining location-specific assets or resource endowments and the firms own unique assets often requires FDI. It requires the firm to establish production facilities where these foreign assets or resource endowments are located. An obvious example of Dunnings arguments is natural resources, such as oil and other minerals, which are specific to certain locations. Dunning suggests that affirm must undertake FDI to exploit such foreign resources. This explains the FDI undertaken by many of the worlds oil companies, which have to invest where oil is located to combine their technological and managerial knowledge with this valuable location-specific resource. Another example is valuable human resources, such as low-cost highly skilled labour. The cost and skill of labour varies from country to country. Since labour is not internationally mobile, according to Dunning it makes sense for a firm to locate production facilities where the cost and skills of local labour are most suited to its particular production process.

7.7 VERTICAL FOREIGN DIRECT INVESTMENT

Vertical FDI takes two forms, there is backward vertical FDI into an industry abroad that provides inputs for a firms domestic production processes. Historically, most backward vertical FDI has been in extractive industries (e.g. oil extraction, bauxite mining, tin mining, and copper mining). The objective has been to provide inputs into a firms downstream operations (e.g. oil refining, aluminium smelting and fabrication, tin smelting and fabrication). Firms such as Royal Dutch/Shell, British Petroleum (BP), RTZ, and Consolidated Gold Field are among the classic examples of such vertically integrated multinationals. A second form of vertical FDI is forward vertical FDI in which an industry abroad sells the outputs of a firms domestic production processes. Forward vertical FDI is less common than backward vertical FDI. For example, when Volkswagen entered the US market, it acquired a large number of dealers rather than distribute its cars through independent US dealers. The question may arise that why firms go to all the trouble and expense of setting up operations in a foreign country. There are two basic answersthe first is a strategic behaviour argument and the second draws on the market imperfections approach.

7.7.1 Strategic Behaviour Argument

According to economic theory, by vertically integrating backward to gain control over the source of raw material, a firm can raise entry barriers and shut new competitors out of an industry. Such strategic behaviour involves vertical FDI if the raw material is found abroad. Another stand of the strategic behaviour explanation of vertical FDI sees such investment not as an attempt to build entry barriers, but as an attempt to circumvent the barriers established by firms already doing business in a country. This may explain

Volkswagens decision to establish its own dealer network when it entered the North American auto market.

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7.7.2 Market Imperfections Approach

The market imperfections approach offers two explanations for vertical FDI. The first explanation revolves around the idea that there are impediments to the sale of knowhow through the market mechanism. The second explanation is based on the idea that investments in specialized assets expose the investing firm to hazards that can be reduced only through vertical FDI. Impediments to the sale of know-how Oil refining companies such as British Petroleum and Royal Dutch/Shell pursued backward vertical FDI to supply their British and Dutch oil refining facilities with crude oil, in the early decades of this century when neither Great Britain nor the Netherlands had domestic oil supplies. Generalizing from this example, the prediction is that backward vertical FDI will occur when a firm has the knowledge and the ability to extract raw materials in another country and there is no efficient producer in that country that can supply raw materials to the firm. Investments in Specialized Assets In this context, a specialized asset is an asset designed to perform a specific task and whose value is significantly reduced in its next-best use. Consider the case of an aluminum refinery which is designed to refine bauxite ore and produce aluminum. Bauxite ores vary in context and chemical composition from deposit to deposit. Each type of ore requires a different type of refinery. Running one type of bauxite through a refinery designed for another type increases production costs by 20 to 100 per cent. Thus the value of an investment in an aluminum refinery depends on the availability of the desired kind of bauxite ore.

7.8 IMPLICATIONS OF FDI FOR BUSINESS

The implications of the theories of horizontal and vertical FDI for business practice are relatively straight forward. First, the location-specific advantages argument associated with John Dunning helps explain the direction of FDI, both with regard to horizontal and vertical FDI. From both an explanatory and a business perspective, the most useful theory is the market imperfections approach. With regard to horizontal FDI, this approach identifies with some precision how the relatives rates of return associated with horizontal FDI, exporting and licensing vary with circumstances. The theory suggests that exporting is preferable to licensing and horizontal FDI is more costly and more risky as long as transport costs are minor and tariff barriers are trivial. As transport cost and/or tariff barriers increase, exporting becomes unprofitable, and the choice is between horizontal FDI and licensing. Since horizontal FDI is more costly and more risky than licensing, other things being equal, the theory argues that licensing is preferable to horizontal FDI. Although licensing may work, it is not an attractive option when one or more of the following conditions exist: (a) the firm has valuable know-how that cannot be adequately protected by a licensing contract (b) the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (c) a firms skills and know-how are not amenable to licensing. Figure 7.1 represents these considerations as a decision tree.

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Firms for which licensing is not a good option tend to be clustered in three types of industries: 1. High-technology industries where protecting firm-specific expertise is of paramount importance and licensing is hazardous. 2. Global oligopolies, where competitive interdependence requires that multinational firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors (as Kodak has done with Fuji). 3. Industries where intense cost pressures require that multinational firms maintain tight control over foreign operations (so they can disperse manufacturing to locations around the globe where factor costs are most favourable to minimize costs). The majority of the limited evidence seems to support these conjectures. In addition, licensing is not a good option if the competitive advantage of a firm is based upon managerial or marketing knowledge that is embedded in the routines of the firm, and/or the skills of its managers, and is difficult to codify in a book of blueprints. This would seem to be the case for firms based in a fairly wide range of industries.
How High are Transportation Costs and Tariffs?

Low

Export

High

Is Know-how amenable to Licensing

No

Horizontal FDI

Yes

Is tight Control over foreign Operation Required?

Yes

Horizontal FDI

No

Can Know-how be protected by licensing Contract

No

Horizontal FDI

Yes

Then License Figure 7.1: A Decision Framework

Firms for which licensing is a good option tend to be in industries whose conditions are opposite to those specified above. Licensing tends to be more common (and more profitable) in fragmented, low-technology industries in which globally dispersed

manufacturing is not an option. Licensing is also easier if the knowledge to be transferred is relatively easy to codify. A good example of an industry where these conditions seem to exist is the fast food industry. McDonalds has expanded globally by using a franchising strategy. Franchising is essentially the service industry version of licensing-although it normally involves much longer-term commitments than licensing. With franchising, the firm licenses its brand name to a foreign firm in return for a percentage of the franchisees profits. The franchising contract specifies the conditions that the franchisee must fulfill if it is to use the franchisors brand name. Thus, McDonalds allows foreign firms to use its brand name as long as they agree to run their restaurants on exactly the same lines as McDonalds restaurants elsewhere in the world. This strategy makes sense for McDonalds because: 1. Like many services, fast food cannot be exported, 2. Franchising economizes the costs and risks associated with opening foreign markets, 3. Unlike technological, brand names are easy to protect using a contract, 4. There is no compelling reason for McDonalds to have tight control over franchisees, and 5. McDonalds know-how, in terms of how to run a fast-food restaurant, is amenable to being specified in a written contract (e.g. the contract specifies the details of how to run a McDonalds restaurant). It may be noted that McDonalds does undertake some FDI to establish master franchisors in each country in which it does business. These master franchisors are normally joint ventures with local companies and their task is to manage McDonalds franchisees within a particular country. In contrast to the market imperfections approach, the product life-cycle theory and Knickerbockers theory of horizontal FDI tend to be less useful from a business perspective. These two theories are descriptive rather than analytical. They do a good job of describing the historical pattern of FDI, but they do a relatively poor job of identifying the factors that influence the relative profitability of FDI, licensing and exporting. The issue of licensing as an alternative to FDI is ignored by both these theories. Finally, with regard to vertical FDI, both the market imperfections approach and the strategic behaviour approach have some useful implications for business practice. The strategic behaviour approach points out that vertical FDI may be a way of building barriers to entry into an industry. The strength of the market imperfections approach is that it points the conditions under which vertical FDI might be preferable to the alternatives. Most importantly, the market imperfections approach points to the importance of investments in specialized assets and imperfections in the market for know-how as factors that increase the relative attractiveness of vertical FDI. Check Your Progress 1 1. Consider the case of IBM and Mexico. IBM was in a fairly strong bargaining position, primarily because Mexico was suffering freedom a flight of capital out of the country during 1985 and 1986, which made the government eager to attract new foreign investment. But IBMs bargaining power was moderated somewhat by the following (a) Size of the proposed investment was unlikely to have more than a marginal impact on the Mexican economy. (b) IBM was looking for a low-labour-cost most desirable location close to the United States.
Contd.

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(c) Before others move in IBM felt it needed to move quickly to establish its own low-cost production facilities. (d) (a) and (b) (e) (a), (b) and (c)

7.9 BENEFITS OF FDI TO HOST COUNTRIES

The four main benefits of FDI to host country are: (i) Resource-transfer effects (ii) Employment effects (iii) Balance-of-payments effect and (iv) Effect on competition and economic growth.

7.9.1 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 countrys economic growth rate. 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 that host-country firms would. Technology can stimulate economic development and industrialization. It can take two forms, both are valuable. Technology can be incorporated in a production process or it can be incorporated in a product. Foreign managers trained in the latest management techniques can often help to improve the efficiency of operations in the host country, whether those operations are acquired or green-field developments. Beneficial spin-offs effects may also arise when local personnel who are trained to occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help to establish indigenous firms. Similar benefits may arise if the superior management skills of a foreign MNE stimulate local suppliers, distributors, and competitors to improve their own management skills.

7.9.2 Employment Effects

The effects of FDI on employment are both direct and indirect. Direct efforts arise when a foreign MNE employs a number of host-country citizens. Indirect effects arise when jobs are created in local suppliers as a result of investment and when jobs are created because of increased local spending by employees of the MNE. The indirect employment effects are often as large as, if not larger than, the direct effects. For example, when Toyota opened a new auto plant in France in 1997,estimates suggested the plant would create 2,000 direct jobs and perhaps another 2,000 jobs in support industries.

7.9.3 Balance-of-Payments Effect

Given the concern about current account deficits, the balance-of-payments effects of FDI can be an important consideration for a host government. There are three potential balance-of-payments consequences of FDI. First, when an MNE establishes a foreign subsidiary, the capital account of the host country benefits from the initial capital inflow (A debit will be recorded in the capital account of the MNEs home country since capital is flowing out of the home country). Second, if the FDI is a substitute for imports of goods or services, it can improve the current account of the host countrys balance of payments. Much of the FDI by

Japanese automobile companies in the United States and United Kingdom, for example can be seen as substituting for imports from Japan. A third potential benefit to the host countrys balance-of payments position arises when the MNE uses a foreign subsidiary to export goods and services to other countries.

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7.9.4 Effect on Competition and Economic Growth

When FDI takes the form of a green-field investment, the result is to establish a new enterprise, increasing the number of players in a market and thus consumer choice. In turn, this can increase competition in a national market and thus consumer choice. In turn, this can increase competition in a national market, thereby driving down prices and increasing the economic welfare of consumers. Increased competition tends to stimulate capital investments by firms in plant, equipment, and R&D as they struggle to gain an edge over their rivals The long-term results may include increased productivity growth, product and process innovations and greater economic growth. FDIs impact on competition in domestic markets may be particularly important in the case of services, such as telecommunications, retailing, and many financial services where exporting is often not an option because the service has to be produced where it is delivered.

7.10 COSTS OF FDI TO HOST COUNTRIES

Three costs of FDI concern host countries: (i) possible adverse effects on competition within the host nation, (ii) adverse effects on the balance of payments, and (iii) the perceived loss of national sovereignty and autonomy.

7.10.1 Possible Adverse Effects on Competition within the Host Nation

Host governments worry that the subsidiaries of foreign MNEs may have greater economic power than indigenous competitors. It is a part of a larger international organization, the foreign MNE may be able to draw on funds generated elsewhere to subsidize its costs in the host market, which could drive indigenous companies out of business and allow the firm to monopolize the market. This concern tends to be greater in countries that have few large firms of their own (generally less developed countries). It tends to be relatively minor concern in most advanced industrialized nations.

7.10.2 Adverse Effects on the Balance of Payments

There are two main areas of concern with regard to the balance of payments. First, the initial capital inflow that comes with FDI must be the subsequent outflow of earnings from the foreign subsidiary to its parent company. Such outflows show up as a debit on the capital account. Some governments have responded to such outflows by restricting the amount of earnings that can be repatriated to a foreign subsidiarys home country. A second concern arises when a foreign subsidiary imports a substantial number of its inputs from abroad, which results in a debit on the current account of the host countrys balance of payments.

7.10.3 Perceived Loss of National Sovereignty and Autonomy

Many host governments worry that FDI is accompanied by some loss of economic independence. The concern is that key decisions that can affect the host countrys economy will be made by a foreign parent that has no real commitment to the host country and over which the host countrys government has no real control.

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7.11 BENEFITS AND COSTS OF FDI TO HOME COUNTRIES

FDI also produces costs and benefits to the home (or source) country.

7.11.1 Benefits of FDI to the Home Country

The benefits of FDI to the home country arise from three sources. First, the capital account of the home countrys balance-of-payments benefits from the inward flow of foreign earnings FDI can also benefit the current account of the home countrys balance of payments if the foreign subsidiary created demands for home country exports of capital equipment, intermediate goods, complementary products, and the like. 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 of capital equipment, intermediate goods, complementary products, and the like. Thus, Toyotas investment in auto assembly operations in Europe has benefited both the Japanese balance-ofpayments position and employment in Japan because Toyota imports some component parts for its European-based auto assembly operations directly from Japan. Third, benefits arise when the home-country MNE learns valuable skills from its exposure to foreign markets that can be transferred back to home country. This amounts to a reverse resource-transfer effect. Through its exposure to a foreign market, an MNE can learn about superior management techniques and superior products and process techniques. These resources can then be transferred back to the home country, contributing to the home countrys economic growth rate.

7.11.2 Costs of FDI to the Home Country

Against these benefits there are apparent costs of FDI for the home (source) country. The most important concerns center around the balance-of-payments and employment effects of outward FDI. The home countrys balance of payments may suffer in three ways. First, the capital account of the balance of the payments suffers from the initial capital outflow required to finance the FDI. This effect, however, is usually more than offset by the subsequent inflow of foreign earnings. 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. With regard to employment effects, the most serious concerns arise when FDI is seen as a substitute for domestic production.

7.12 POLITICAL RISK AND FDI

Political risk refers to the potential losses to the parent firm resulting from the outright expropriation of foreign assets to an unexpected change in the tax laws that hurt the profitability of foreign projects. Depending on the incidence, political risk can be classified into two types: 1. Macro risk: Where all foreign operations are affected by adverse political developments in the host country. Example: - Communist victory in China in 1949. 2. Micro risk: Where only selected areas of foreign business operations or particular foreign firms are affected. Example: - Enron project was cancelled by the BJP government in the State of Maharashtra.

Depending on the manner in which firms are affected, political risk can be classified into three types: 1. Transfer Risks: which arise from uncertainty about cross-border flows of capital, payments, know-how and the like. Example: - Unexpected imposition of Capital Controls inbound or outbound and withholding taxes on dividend and interest payments. 2. Operational Risks: which are associated with the uncertainty about the host country policies affecting the local operation of the MNCs. Example: Unexpected changes in environment policies, sourcing/local content requirement, minimum wage law and restrictions on access to local credit facilities. 3. Control Risks: which arise from uncertainty about the host countrys policy regarding ownership and control of local operations. Example- restrictions imposed in the maximum ownership share by foreigners, mandatory transfer of ownership to local firms over a certain period of time and nationalisation of local operations of MNCs. Check Your Progress 2 1. Mention the benefits of FDI to host country. . . 2. Mention the three costs of FDI to host country. . . 3. What is Political Risk? . .

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7.12.1 Measurement of Political Risk

It is necessary to evaluate a set of key factors such as: The host countrys political and government system. If a country has too many political parties and frequent changes in government (like Italy for example), government policies may become inconsistent and discontinuous, creating political risk. Track records of political parties and their relative strength. This reveals a great deal about how they would run the country. Integrated into the world system. If a country is politically and economically isolated and segmented from the rest of the world, it would be less willing to observe the rules of the game. The host countrys ethnics and religious stability, e.g. Rwanda, Northern Ireland, Israel, Sri Lanka. Regional security: Real and potential aggression from a neighbouring country is a major source of political risk. Kuwait is a recent example. Key economic indications: Often political events arise because of economic situations. For example, persistent trade defects may induce a host countrys government to delay or step interest payments to foreign lenders, erect trade barriers or suspend the convertibility of the local currency, causing major difficulties for MNCs.

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7.12.2 How to Manage/Mitigate Political Risk

1. MNCs can take a conservative approach to foreign investment projects when faced with political risk. When a foreign project is exposed to political risk, the MNC can explicitly incorporate political risk into the Capital budgeting process and adjust the projects NPV accordingly. The firm may do so either by reducing expected cash flows or by increasing the level of capital. The MNC can undertake the foreign project only when the adjusted NPV is positive. 2. To diversify the projects in different countries so as to diversify the political risk. 3. Once a MNC decides to undertake a foreign project, it can take variable measures to minimise its exposure to political risk e.g. to form a joint venture with a local company; forming a consortium of international companies to undertake the foreign project; use local debt to finance the foreign project. 4. MNCs may purchase insurance against the hazard of political risk. Such insurance policies which are available in many advanced countries are specially useful for small firms that are less equipped to deal with the political risk on their own.

7.12.3 Country Risk: What is This?

Country risk is a broader measure of risk than political risk as the former encompasses political risk, credit risk and other economic performances. As of March 1999, countries like Switzerland, Germany, Luxembourg and US were considered practically free of political risk. In contrast, countries like Israel, China, India, Mexico, Brazil and Argentina were rated as having substantial political risk. Countries such as Indonesia, Russia and Yugoslavia were rated as among the most politically risky countries.

7.13 LET US SUM UP

Foreign direct investment occurs when a firm invests directly in facilities to produce a product in a foreign country. It also occurs when a firm buys an existing enterprise in a foreign country. Horizontal FDI is FDI in the same industry abroad as a firm operates at home. Vertical FDI is FDI in an industry abroad that provides inputs into or sells output from a firms domestic operations. Several factors characterized FDI trends over the past 20 years; (a) there has been a rapid increase in the total volume of FDI undertaken, (b) there has been some decline in the relative importance of the United States as a source for FDI, while several other countries have increased their share of total FDI outflows, (c) an increasing share of FDI seems to be directed at the developing nations of Asia and Eastern Europe, while the United States has become a major recipient of FDI, and (d) there has been an increase in the amount of FDI undertaken by firms based in developing nations. High transportation costs and/or tariffs imposed on imports help explain why many firms prefer horizontal FDI or licensing over exporting. Impediments to the sale of know-how explain why firms prefer horizontal FDI to licensing These impediments arise when (a) a firm has valuable know-how that cannot be adequately protected by a licensing contract, (b) a firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (c) a firms skills and know-how are not amenable to licensing. Knickerbockers theory suggests that much FDI is explained by imitative strategic behaviour by rival firms in an oligopolistic industry. Vermons product life-cycle theory suggests that firms undertake FDI at particular stages in the life cycle of products they have pioneered.

Dunning has argued that location-specific advantages are of considerable importance in explaining the nature and direction of FDI. According to Dunning, firms undertake FDI to exploit resource endowments or assets that are location-specific. Backward vertical FDI may be explained as an attempt to create barriers to entry by gaining control over the source of material inputs into the down stream stage of a production process. Forward vertical FDI may be seen as an attempt to circumvent entry barriers and gain access to national market. The market imperfections approach suggests that vertical FDI is a way of reducing a firms exposure to the risks that arise from investments in specialized assets. From a business prescriptive, the most useful theory is probably the market imperfections approach, because it identifies how the relative profit rates associated with horizontal FDI, exporting, and licensing vary with circumstances. The benefits of FDI to a host country arise from resource-transfer effects, employment effects, balance of payments effects, and its ability to promote competition. The costs of FDI to a host country include adverse effects on competition and balance of payments and a perceived loss of national sovereignty. The benefits of FDI to the home (source) country include improvement in the balance of payments as a result of the inward flow of foreign earnings, positive employment effects when the foreign subsidiary creates demand for home country exports and benefits from a reverse resource-transfer effect. A reverse resource-transfer effect arises when the foreign subsidiary learns valuable skills abroad that can be transferred back to the home country. The costs of FDI to the home country include adverse balance-of-payments effects that arise from the initial capital outflow and from the export substitution effects of FDI. Costs also arise when FDI exports jobs abroad.

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7.14 LESSON END ACTIVITY

Japanese MNCs such as Toyota, Toshiba and Matsushita made extensive investment in South East Asian countries like Thailand, Malaysia, Indonesia and India. In your opinion, what forces are driving Japanese investments in these regions?

7.15 QUESTIONS FOR DISCUSSION

1. What are the advantages and disadvantages of FDI as compared to a licensing agreement with a foreign partner? 2. Recently, many foreign firms from both developed and developing countries acquired high tech US firms. What might have motivated these firms to acquire US firms? 3. Firms should not be investing abroad when there is a need for investment to create jobs at home. Discuss. 4. Inward FDI is bad for (a) A developing economy and (b) A developed economy and should be subjected to strict controls! Discuss. 5. Compare and contrast these explanations of horizontal FDI: the market imperfections approach, Vermons product life-cycle theory, and Knickerbockers theory of FDI. Which theory do you think offers the best explanation of the historical pattern of horizontal FDI? Why? 6. Compare and contrast these explanations of vertical FDI: the strategic behaviour approach the market imperfections approach, which theory do you think offers the best explanation of the historical pattern of vertical FDI? Why?

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Check Your Progress: Model Answers

CYP 1 1. CYP 2 1. Benefits of FDI to host country are: (i) Resource-transfer effects (ii) Employment effects (iii) Balance of Payment effects (iv) Effect on competition and economic growth 2. Cost of FDI concern Host Countries: (i) Possible adverse effects on competition within the host nation (ii) Adverse effect on the balance of payments (iii) Perceived loss of national sovereignty and autonomy. 3. Political Risk: It refers to the potential losses to the parent firm resulting from the outright expropriation of foreign assets to an unexpected change in the tax laws that hurt the profitability of foreign projects. (e)

7.16 SUGGESTED READINGS

Cherenilan Francis, International Business, Text and Cases 3rd, Edition, Prentice-Hall of India Private Limited Charles W. L. Hill, International Business Competing in the Global Marketplace, 4th Edition, Tata McGraw Hill Publishing Company Limited