Unit 2.

Foreign Direct Investment

Learning Objectives

1. Define foreign direct investment and portfolio

investment.
2. Describe each of the theories that attempt to
explain why foreign direct investment occurs.
3. Discuss the important management issues in the
foreign direct investment decision.
4. Explain why governments intervene in the free flow
of foreign direct investment.
5. Discuss the policy instruments that governments
use to restrict and promote foreign direct
investment.
1. Foreign direct investment (FDI)
and Portfolio Investment
1. Foreign direct investment (FDI): Purchase of
physical assets or a significant amount of the
ownership (stock) of a company in another
country to gain a measure of management
control.

2. Portfolio investment (PI): Investment that does

not involve obtaining a degree of control in a
company.
1. Foreign direct investment (FDI) and
Portfolio Investment
PI
Be made without leaving the
home country through an
international investment broker
or a banking institution
Investors buy shares and
debentures that can be
liquidated at market value at
any time
Don’t take the control of the
company
FDI
Involve the establishment of
plants or distribution networks
abroad
A long-term commitment where
capital funds will be tied up for
a long time
Have the objective of controlling
or sharing control over
production, R&D and sales.
Reasons for growth of FDI

 Globalization
• The forces causing the globalization of
industries are encouraging growth in FDI.
• Lower trade barriers encouraged FDI in those
markets that promised adequate sales
volumes.
• Companies could produce in the most efficient
and productive locations in the world, and
simply export to their markets worldwide.
• Increasing globalization is also causing a
growing number of international companies
from emerging markets to undertake FDI.
 Reasons for growth of FDI
 Mergers and Acquisitions
• The number of mergers and acquisitions (M&A) and
their exploding values also underlie the growth in
FDI flows.
• A great deal of M&A activity in domestic markets is
causing companies to venture abroad for new M&A
targets.
• Many cross-border M&A deals are driven by many
companies to
 Get a foothold in a new geographic market
 Increase a firm’s global competitiveness
 Fill in companies’ product lines in a global industry
 Reduce costs in such areas as R&D, production, or
distribution
Reasons for growth of FDI

 Role of Entrepreneurs and Small Businesses

• Entrepreneurs and small businesses also
contribute to the expansion of FDI flows.
• Unhindered by many of the constraints of a
large company, entrepreneurs investing in
other markets often demonstrate an inspiring
can-do spirit and ingenuity.
2. Explanations for FDI: Theories

04 main theories attempt to explain why

companies engage in FDI:
 International Product Life Cycle

 Market Imperfections (Internalization)

 Eclectic Theory

 Market Power
International Product Lifecycle
A company will begin by exporting its product and later
undertake FDI as a product moves through its lifecycle.
• New product stage: A good is produced in the home
country because of uncertain domestic demand and
to keep production close to the research department
that developed the product.
• Maturing product stage: The company directly
invests in production facilities in those countries
where demand is great enough to warrant its own
production facilities.
• Standardized product stage: increased competition
creates pressure to reduce production costs. The
company builds production facilities in low-cost
developing nations to serve its markets around the
world.
 Market Imperfections

When an imperfection in the market makes a

transaction less efficient than it could be, a
company will undertake FDI to internalize the
transaction and thereby remove the
imperfection.
02 market imperfections:
• Trade barriers such as tariffs cause companies to
undertake FDI
• Specialized knowledge: When a company’s
specialized knowledge is embodied in its
employees, the only alternative to exploit a
market opportunity in another nation may be to
undertake FDI.
 Eclectic Theory

Firms undertake FDI when the features of a

particular location combine with ownership
and internalization advantages to make a
location appealing for investment.
 Eclectic Theory
• A location advantage is the advantage of locating a
particular economic activity in a specific location
because of the characteristics (natural or acquired) of
that location such as natural resources, or productive
workforce
• An ownership advantage is an advantage that the
company has due to its ownership of some special
asset, such as brand recognition, technical knowledge,
or management ability.
• An internalizing advantage is the advantage that arises
from internalizing a business activity rather than leaving
it to relatively inefficient market.
Market Power
A firm tries to establish a dominant market
presence in an industry by undertaking FDI.
• The benefit of market power is greater profit
because the firm is far better able to dictate
the cost of its inputs and/or the price of its
output.
• One way a company achieves market power
is through vertical integration – the extension
of company activities into stages of
production that provide a firm’s inputs
(backward integration) or absorb its output
(forward integration)
3. Management Issues in the FDI
Decision
1. Control
2. Purchase-or-Build Decision
3. Production Costs
4. Customer Knowledge
5. Following Clients
6. Following Rivals
Control
• When many companies invest abroad
greatly concerned with controlling the
activities occurring in the local market of
reasons.
• But a greater ownership percentage does
not guarantee greater control.
• Also, local governments might require a
company to hire local managers or require
that all goods produced in a local facility
be exported so they do not compete with
products of native firms.
Purchase-or-Build Decision
• Another matter of concern is whether to purchase
an existing business or build an international
subsidiary from the ground up ( called a greenfield
investment.
• An acquisition generally provides the investor with
an existing plant and equipment as well as
personnel.
• Factors that reduce the appeal of purchasing
existing facilities include obsolete equipment, poor
relations with workers, and an unsuitable location.
• Adequate facilities are sometimes simply
unavailable and a company must go ahead with a
greenfield investment
Production Costs
• The cost of production in a market is also
important. Labor regulations can increase
the hourly cost of production several times.
• One approach companies use to contain
production costs is rationalized production -
a system of production in which each of a
product's components are produced in the
location in which the cost of producing that
component is lowest.
• All the components are then brought
together at one central location for assembly
into the final product.
Customer Knowledge
• A local market presence might help companies
gain valuable knowledge about the behavior of
buyers that it could not obtain from the home
market.
• Company might want to produce in a nation that
has a quality image in a certain product.
 Following Clients

• Firms commonly engage in FDI when doing

so puts them close to firms for which they
act as supplier - called following clients.
• The practice tends to result in clusters
whereby companies that supply one
another's inputs congregate in a certain
geographic region.
Following Rivals

• Companies engage in FDl simply

because a rival does
• They do not want to be shut out of a
potentially lucrative market - called
following rivals
4. Government intervention in FDI
• Both host and home of foreign interfere in the free
countries free flow of FDI for a variety of reasons -
many of them related to their balance of
payments position.
• A country's balance of payments is a national
accounting system that records all payments to
entities in other countries and all receipts coming
into the nation.
• International transactions that result in payments
(outflows) to entities in other nations are
reductions in the balance of payments accounts.
• International transactions that result in receipts
(inflows) from other nations are additions to the
balance of payments accounts.
• The current account is a national account that
records transactions involving the import and
export of goods and services, income receipts on
assets abroad, and income payments on foreign
assets inside the country.
• A current account surplus (trade surplus) occurs
when a country exports more goods, services
vices, and income than it imports.
• A current account deficit (trade deficit) occurs
when a country imports more goods, services, and
income than it exports.
• The capital account is a national account that
records transactions that involve the purchase or
sale of assets.
Reasons for host country intervention in FDI

• To protect their balance of payment.

• Obtain Resources and Benefits
 Reasons for host country intervention in FDI
• To protect their balance of payment
 Allowing FDI to come in gives a nation a
balance-of-payment boost.
 Countries also improve their balance-of-
payments position from the exports of local
production operations created by FDI.
 When direct investors send profits made locally
back to the parent company in the home
country, the balance of payments decreases.
Reasons for host country intervention in FDI
Obtain Resources and Benefits
• Access to Technology: Local investment in
technology also tends to crease the
productivity and competitiveness of the
nation.
• Management skills: By encouraging FDI,
nations can also bring in people with
management skills who can train locals and
thus improve the competitiveness of local
companies.
• Employment: Many local jobs are also
created as a result of incoming FDI.
Reasons for home country intervention
• Investing in other nations sends resources
out of the home country – lowering the
balance of payments.
• Profits on assets abroad that are returned
home increase a home country’s balance of
payments.
• Outgoing FDI may ultimately damage a
nation’s balance of payments by taking the
place of its exports.
• Jobs resulting from outgoing investment may
replace jobs at home that were based on
exports to the host country.
5. Government policy instrument
and FDI
Host countries: Restriction
• Ownership restriction
• Performance demands
Host countries: Promotion
• Financial incentives
• Infrastructure improvements
Host countries: Restriction
• Ownership restriction
 Governments can impose ownership restrictions
that prohibit nondomestic companies from investing
in businesses in cultural industries and those vital
to national security.
• Performance demands
Governments can also create performance
demands that influence how international
companies operate in the host nation.
Performance demands can take the form of
stipulations regarding the portion of the product's
content originating locally, the portion of output
that must be exported, or requirements that certain
technologies be transferred to local businesses.
Host countries: Promotion
• Financial incentives
 Host governments can also grant
companies tax incentives such as lower
tax rates or offer to waive taxes on local
profits for a period of time.
 A country may also offer low-interest
loans to investors.
 The downside of incentives such as
these is that it can allow multinationals
to create bidding wars between locations
that are vying for the investment.
Host countries: Promotion
• Infrastructure improvements
Because of the problems associated with
financial incentives, some governments
prefer to lure investment by making
local infrastructure improvements -
better seaports suitable for
containerized shipping, improved roads,
and increased telecommunications
systems.
5. Government policy instrument
and FDI
Home countries: Restriction
-Differential tax rates
-Outright sanctions
Home countries: Promotion
-Offer insurance
-Grant loans
-Offer tax breaks
-Apply political pressure
Home countries: Restriction
• Differential tax rates
Impose differential tax rates that charge income
from earnings abroad at a higher rate than
domestic earnings
• Outright sanctions
Impose outright sanctions that prohibit
domestic firms from making investments in
certain nations
Home countries: Promotion
• Offer insurance
Offer insurance to cover the risks of investments
abroad.
• Grant loans
Grant loans to firms wishing to increase their
investments abroad. A home-country government may
also guarantee the loans that a company takes from
financial institutions.
• Offer tax breaks
Offer tax breaks on profits earned abroad or negotiate
special tax treaties.
• Apply political pressure
Apply political pressure on other nations to get them to
relax their restrictions on inbound investments
Questions for Review
1. What is FDI? Explain how FDI differs from
portfolio investment.
2. What are three factors contributing to the
growth in FDI?
3. Describe how the international product lifecycle
explains FDI. What are the three product
stages?
4. How does the theory of market imperfections
(internalization) explain FDI?
Questions for Review
5. Explain the eclectic theory. Identify the 3
advantages that must be present for FDI to
occur, according to the theory?
6. How does the theory of market power
explain the occurrence of FDI?
7. Why is control important to the FDI
decisions?
8. For what reason do host countries intervene
in FDI?
Questions for Review
9. For what reasons do home counties
intervene FDI?
10. What are the main methods host
countries use to restrict and promote FDI?
11. What methods do home countries use to
intervene in FDI?