Study Guide - Chapter 8 – Foreign Direct Investment

Brief chapter summary and most important points

Introduction and chapter coverage

Up to this point in the course we have talked about only one form of international business; that is
international trade (imports and exports). However, a larger and more important form of international
business is Foreign Direct Investment (FDI). FDI is when a company takes money that it has earned in its
domestic operations and invests that money by setting up a business in another country. The
‘headquarters’ (or home) of the company then has control over the international ‘subsidiary’ that it has
invested in. Of course, like any investment, the HQ hopes that it will make money from its international
investment and that through profit ‘repatriation’ the shareholders of the firm will be rewarded. This
chapter provides a definition for FDI, talks about its growth and reasons for its growth in the past fifty
years. It also looks at the ‘direction of FDI flow’ and notes that China has become one of the world’s
largest recipients of incoming FDI. The main types of FDI are identified and the reasons why FDI is
preferred as an entry mode are explained with reference to relevant theory.

The second half of the chapter discusses government policy and FDI. A country that receives incoming
FDI (the host country) benefits because it gets more jobs created in its economy and also has access to
new technology from other countries. However, there are also disadvantages, the new ‘foreign’ firm
may harm local competitors and eventually will send the profits made back to another country. A
country that has outgoing FDI (the home country) also benefits in that its firms get access to new
markets and can win profits overseas. However, outgoing FDI may also lead to a loss of jobs at home
and a fall of exports as goods are now produced in another country rather than being manufactured
there. This chapter identifies the costs and benefits of FDI in more detail. In order to understand all of
the class you need to know a little bit about the ‘Balance of Payments’. This is a record of all financial
transactions (trade and investment, government payments etc) between countries. If you haven’t
covered this topic before, look at the textbook, or for a further explanation visit:

https://www.investopedia.com/terms/b/bop.asp

Definition, growth and flow of FDI

As stated above foreign investment is when a firm invests money from the ‘home’ country to build its
operations in another ‘host’ country. These operations may be manufacturing facilities, retail outlets,
R&D operations etc. There are substantial amounts of investment made between countries however
most of this is not FDI, rather this is cross-border investments made solely for investment purposes
(buying shares in foreign enterprises) which is referred to as portfolio investment. FDI requires not only
some form of foreign ownership but also a degree of management control of the foreign enterprise.
The UN and the textbook suggests that an investment qualifies as FDI when over 10% of the shares are
owned by the foreign investor.

Whereas trade has been around for over a thousand years, FDI is a more recent phenomenon, FDI prior
to 1950 was limited to the very largest corporations and the difficulties of making and managing foreign
investments restricted its growth. However, over the past fifty years FDI has vastly increased in scale
and it has grown at a rate far exceeding growth in trade and growth in world GDP. FDI is measured in
two ways, flow and stock. FDI flows represent the net yearly investments from one country to another,
how much newly invested money is flowing to China from the U.S. for example (minus investments
repatriated by U.S. firms); this figure is the one most often referred to in newspaper and TV headlines
when they report ‘FDI is up xx% etc.’ However, a more important figure is FDI stock which is the
cumulative amount of FDI investment from one place to another, that measures, for example, the total
value of all current American FDI investments in China at the present time. Another way of measuring
FDI is through production realised from FDI investments, the total value of goods and services produced
by FDI; on a global basis this measure typically exceeds that of total international trade.

Traditionally most FDI has been from developed countries in to other developed countries, this is
explained by the fact that firms mostly sought other developed countries in which to first expand their
international operations and also by the fact that many developing countries were closed to any form of
FDI. The U.S., Japan, Britain have traditionally been the largest foreign investors and the U.S. has in
most years also been the largest recipient of incoming FDI. Over the past few decades however,
developing countries (in particular China) have become the recipient of larger and larger amounts of
incoming FDI, and in more recent years China and other developing countries have increased their
outward investments also.

The factors that have led to the growth of FDI are largely the same ones that we discussed when we
talked about globalization in chapter 1. Falling trade and investment barriers have particularly impacted
the ability of foreign companies to build operations in countries that were previously ‘closed’, practically
all of the FDI in China for example has come since Deng Xiaoping ‘opened’ China to FDI in the late
1970’s. Additionally, advances in telecommunications have meant that it is now possible to manage and
oversee foreign operations in a way that was not possible before, it is now possible to integrate
overseas subsidiaries in to a global supply chain making use of advanced technologies. From a
theoretical perspective we can again explain the growth of FDI through the lens of ‘comparative
advantage’, Nike for example performs its design and marketing activities in the U.S., where it has that
advantage, but manufactures its shoes in Indonesia and Vietnam where those countries have an
advantage. FDI therefore can be seen as increasing world efficiency and maximising the use of global
resources.

Types of FDI and rationale for FDI use

There are three types of outward FDI:

Greenfield investments:
This is where the foreign company invests in developing its foreign
operations from scratch, establishing a wholly new operation. Building
an overseas operation in this way can be time-consuming and difficult, it
can be challenging to enter the local market for example of local
competitors who are already established there.

Acquisition: Here the foreign company buys an existing already established foreign
company and takes over its operations. This is the more common form
of FDI and results in the bulk of FDI flows (often referred to as M&A or
mergers and acquisitions). Such methods allow the foreign firm to
 quickly establish operations although it can be costly in terms of
acquisition cost.

Joint development:
This refers to making use of some form of joint venture arrangement
with a local firm. This method can reduce the initial investment cost
and make it easier to enter an unfamiliar foreign territory. On the other
hand, jointly running an operation with a foreign partner is not always
easy and profits need to be shared.

As foreign firms competing in an unfamiliar environment in theory suffer from the ‘liability of
foreignness’ some have suggested that FDI is an inherently inefficient entry mode and foreign firms
would in theory be better to buy from local manufacturers or contract with local firms in some form of
licensing arrangement. Theories have been developed however to explain why FDI does occur, the most
commonly cited is Dunning’s ‘eclectic’ theory sometimes referred to OLI theory.

The theory suggests that FDI will occur under three conditions, firstly that the foreign firm has an
ownership advantage, that is the ability to do something or produce something more efficiently that the
domestic firms; that there is a location advantage, that is that it makes sense to produce in the foreign
location rather than at home and that there is an internalization advantage; that is a reason to do it
within the firm rather than licensing to a local manufacturer (to protect the technology for example). If
all three advantages exist, then FDI will occur.

Government policy and FDI

The previous two chapters discussed international trade theory and then government policy to trade.
This chapter combines both issues, the second half of it focusing on government policy to FDI.

There are traditionally two competing government viewpoints on FDI, the free-market view and the
radical view. The free market view suggests that FDI benefits the world economy (through the means of
comparative advantage discussed above) and that firms should be free to make their own investment
decisions and governments should allow their firms to invest overseas if they wish and foreign firms
should also be able to invest freely in their country. Alternatively, the radical view of FDI holds that FDI
is inherently bad for the domestic economy and should be discouraged. Radicals consider that the
incoming FDI is only incoming because it wants to take some advantage from the domestic economy,
whether that be in the form of the local market, cheap labour, the country’s natural resources etc.

Most countries these days follow a policy of ‘pragmatic nationalism’ when it comes to assessing
incoming FDI. This means that they look at each proposed FDI project and consider whether on balance
it brings more benefits or costs to the country. The in-class activitythat will be conducted provides an
opportunity to conduct such an exercise; when deciding upon the benefits from any FDI proposal the
factors that will be considered include:

Jobs: Does the proposed investment provide new jobs for local workers, what quality of jobs
are created?

Technology: Does the investment bring in new technologies which may subsequently be transferred
to local firms?

Local impact: Does the new investment make use of locally produced inputs or spur job creation and
increased competitiveness of local firms? Or does the new investment replace local
firms and stunt domestic competition?

BoP: The impact on a country’s balance of payments Is often the most difficult thing to assess
because most projects involve both BoP benefits and costs. The country needs to
consider how much incoming capital does the project bring in? what will this capital be
used for? What will be the long-term impact on imports and exports?

Sovereignty: Does the proposed investment compromise national security or harm national
sovereignty.

The host country after assessing the relative benefits of a proposal may support the proposal, and even
actively encourage projects with significant benefits to the local economy. Most countries have
‘investment promotion’ branches of the government which seek out incoming investment that bring in
employment and new technologies, the country may offer investment incentives such as free land or no
taxes for a period in order to encourage new projects. Where proposals are less attractive the host
country may refuse to accept the FDI, or more likely require that the proposal is changed in some
manner (such as a local content requirement or export commitments) before it is accepted.

The home country (where the FDI is coming from) is generally supportive of outgoing FDI as it extends
the influence of the country overseas and increases potential revenues and opportunities for domestic
firms. However, home governments may also restrict some outgoing FDI if it leads to domestic job
losses, transfers technology to a strategic rival or is seen as a wasteful use of foreign currency.

Conclusions and managerial implications

For companies, the decision to engage in FDI should not be taken lightly, and in practice most firms
utilize other entry modes such as exporting or licensing before progressing to the use of FDI. It can be
costly both in terms of money as well as managerial attention and this can create opportunity costs.
For governments, FDI can be a significant contributor to national development and economic growth,
however steps need to be taken to ensure that incoming FDI is beneficial on an overall basis to the
domestic economy and avoids the loss of national sovereignty and resources.

Resources supplied and required and suggested reading

View the PowerPoint files of Chapter 8 available on Moodle

Read Chapter 8 from the assigned textbook

Keep yourself informed by reading and watching news reports of the ongoing trade and investment
disputes between China and the U.S. and the actions that each side are taking

Participate in the class and discuss with group-mates the in-class activity

Review the same class session made available as a recording

Watch (if you can) the movie ‘American Factory’. This movie won the 2019 Oscar award for best
documentary (it was also the first movie made by President’s Obama new film production company). It
is available on Netflix so you will need an account with them to view it. The documentary is both
educational and very entertaining and hopefully you would enjoy watching. The video details the case
of a Chinese firm who acquires an old dis-used factory in the American mid-west and opens it up again
to produce glass windscreens for the automobile industry. It touches on many issues in the course
including FDI and culture.

Answer the 10 multiple choice questions covering chapter 6 that have been prepared as a turnitin
assignment available on Moodle

Complete the in-class exercise that is included at the end of this study guide.
 In your groups: complete the following activities:

Due to the generally positive outcomes associated with incoming FDI most countries make a significant effort to
attract projects to their country. Government departments, or branches within these departments, have been
established by most countries to assist companies and provide information for those who might plan to invest.
Make an effort to find the relevant government websites for each of the two countries you have been assigned.
In google, search for (country name) and investment and promotion or investment and development or related
words to find these sites. Once found, see if there is information there which can help you with the project,
particularly whether governments offer any kind of investment incentives for firms planning to invest in the
country.

By now, you should have already collected a lot of information for your countries and located specific indexes
which provides the information you need. Now is the time to start thinking about how you are going to present
this information. Good clear tables and charts will help in your presentation, and you can reuse these same tables
in your final reports. Make a start on preparing these tables and charts now; for each one you prepare make sure
that they:

 Are clearly titled and the title actually matches the content of the chart
 That the measuring units are clearly identified (US$, millions, kilograms or whatever)
 That the data presented for each country is measuring the same thing
 If using indexes, make sure that you explain the scale used (is it a score out of 10? Out of 100? Is 1 a very
high score or a very low score?
 Make sure to add the source of the data or the index you have used on each chart
 Have a consistent visual style across the presentation.

Take a look at the following suggested articles also available on Moodle

‘Chinese companies shed $40 billion in global assets’ Financial Times September 16th 2019

How after years of overseas acquisitions and expansion, China is now seeing a significant
retrenchment of capital.

‘China buys into the U.S.’ Fortune March 1st 2017

Graphic showing size and nature of Chinese investment in the U.S.

‘American Made, Chinese Owned’ Fortune May 24th 2010

Report on Chinese FDI into the U.S. motivations include more direct access to US customers and
ability to get around import tariffs.
‘China Shifts Blueprint on FDI’ Asian Wall Street Journal November 10th 2006

How Chinese policy to incoming FDI is changing. Now they are looking primarily for high
technology ventures and skills-building activities rather than just assembly operations. Although
the article is old it shows how China’s objectives with respect to incoming FDI have changed
over time.
 In-class Exercise

Chapter 8: Foreign Direct Investment

You work in Taiwan’s Department of Trade and Industry. The Minister for Trade has asked you to look
over three proposed FDI projects and report back to her. Details of the three proposals are as follows.

A. Ford motor company wants to invest $100 Million in Taiwan. This will be used to set up a
state-of-the-art assembly plant that will make use of advanced Japanese robotic technology.
Once the plant has been established it will assemble Ford’s latest edition of luxury cars for
sale in Taiwan.

B. A small Malaysian computer company wants to invest $4 Million to set up a small computer
assembly plant. It will buy components from Taiwan’s many component suppliers and then
assemble them locally. It will be a fairly low-tech operation. Completed computers will be
sold mostly in Malaysia, Thailand etc.

C. A German steel manufacturer wants to buy Taiwan Steel for an investment of $40 Million.
Taiwan Steel is at present owned by the government but is making losses of around $10
Million per year, it is the only steel-making firm left operating in Taiwan. Assets of the firm
are worth around $80 Million but the German firm is offering only half that because of the
steady string of losses in recent years. Almost all of the output of the firm is sold locally in
Taiwan. The German firm hopes to turn things around by bringing in new technology and new
management techniques.

1. Rank the three investment proposals. Which of the three is most attractive to the Taiwanese
Government, which is least attractive...... why?

2. What should the Taiwanese government do in order to attract the most attractive
investment?

3. What conditions should the Taiwanese government set in place before allowing the least
attractive investment?