5

Chapter

Foreign Direct Investment

 6-2

Learning Objectives

1. What are the types of foreign direct investment (FDI)?

2. What strategies encourage an MNE to engage in such

investment?

3. Do companies share strategic goals in pursuing FDI?

4. What benefits would you cite to MNE executives to attract them

to establish a subsidiary?

5. What drives FDI distribution and patterns?

6. Why is Africa left out of the FDI mix?

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 6-3

Chapter Focus

This chapter seeks to identify the economic rationale that

underlies Foreign Direct Investment. For example, why do
some firms prefer FDI to exporting or licensing. Is the need for
control, part of the answer?

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 6-4

Foreign Direct Investment

FDI occurs when a firm invests directly in facilities to produce
and/or market a product in a foreign country.
Once a firm undertakes FDI, it becomes a multinational
enterprise (multinational = more than one country).
FDI takes two forms:
Greed-field investment: establishing a wholly new operation
in a foreign country.
Acquiring or merging with an existing firm in the foreign
country.
Investing in foreign financial instruments (Portfolio Investment)
IS NOT FDI.

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 6-5

Definition and Types of FDI

Foreign Direct Investment: When a firm invests directly in

production or other facilities, over which it has effective control,
in a foreign country.

Manufacturing FDI requires the establishment of production

facilities.

Service FDI requires building service facilities or an investment

foothold via capital contributions or building office facilities.

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 6-6

Cont’d

Foreign subsidiaries – overseas units or entities.

Host country – the country in which a foreign subsidiary

operates.

Flow of FDI – the amount of FDI undertaken over a given time.

Stock of FDI – total accumulated value of foreign-owned

assets.

Outflows/Inflows of FDI – the flow of FDI out of or into a

country.

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 6-7

FDI versus Foreign Portfolio Investment

Foreign Portfolio Investment – the investment by individuals,

firms, or public bodies in foreign financial instruments.

Stocks, bonds, other forms of debt.

Differs from FDI, which is the investment in physical assets.

Portfolio theory – the behavior of individuals or firms

administering large amounts of financial assets.

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 6-8

Types of FDI

Horizontal FDI – the MNE enters a foreign country to produce

the same products product at home.

Conglomerate FDI – the MNE produces products not

manufactured at home.

Vertical FDI – the MNE produces intermediate goods either

forward or backward in the supply stream.

Liability of foreignness – the costs of doing business abroad

resulting in a competitive disadvantage.

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 6-9

Flow and Stock of FDI

Flow:
The amount of FDI undertaken over a given period of
time (usually one year).
Stock:
Total accumulated value of foreign-owned assets at a
given time.

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 6-10

FDI Outflows(1982-2000)

1400
1200
1000
800
600 $ Billions
400
200
0
82- 92 94 96 98 2000 Figure 6.1
86

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 6-11

FDI Flows by Region

600
500
400 Value Exports
300 World GDP
Index

200 World FDI

100
0

Figure 6.2

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 6-12

Reasons for FDI Growth

FDI circumvents potential future trade barriers.

Dramatic political and economic changes occurring in

developing countries.

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 Increase in the Number of Bilateral Trade 6-13

Treaties

2000
1800
1600
1400
1200
Treaties
1000
Countries
800
600
400
200
0
1993 1995 1998 1999 2000

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 6-14

FDI into Developed and Developing Nations:

1990-2000

1200

1000 Dev Nations

800 Devg. Nations

W. Europe
$Billion

600
N. Amer.
400 Asia
200 L. Amer.

0
94 95 96 97 98 99 2000
Figure 6.3

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 6-15

Inward FDI Flows as a Percentage of Gross Fixed

Capital Formation, 1998

Asia
L. Amer.
N. Amer.
W. Europe
Devg. Nations
Dev. Nations
World

0 10 20 30

Figure 6.4

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 6-16

FDI Outflows by
Selected Countries, 1994-1999
300

250 U.S.
U.K.
200
Netherlands
150
Germany
100 Japan
50 Spain
France
0
1994 1995 1996 1997 1998 1999 2000

Figure 6.5

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 6-17

Entry Mode
The manner in which a firm chooses to enter a foreign market
through FDI.
 International franchising
 Branches
 Contractual alliances
 Equity joint ventures
 Wholly foreign-owned subsidiaries
Investment approaches:
 Greenfield investment (building a new facility)
 Cross-border mergers
 Cross-border acquisitions
 Sharing existing facilities

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 6-18

The Strategic Logic Behind FDI

Resources seeking - looking for resources at a lower real cost.

Market seeking - secure market share and sales growth in

target foreign market.

Efficiency seeking - seeks to establish efficient structure

through useful factors, cultures, policies, or markets.

Strategic asset seeking - seeks to acquire assets in foreign

firms that promote corporate long term objectives.

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 6-19

Enhancing Efficiency from Location Advantages

Location advantages are defined as the benefits arising from a
host country’s comparative advantages.
Better access to resources
Lower real cost from operating in a host country
Labor cost differentials
Transportation costs, tariff and non-tariff barriers
Governmental policies

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 Improving Performance from Structural 6-20

Discrepancies

Structural discrepancies are the differences in industry

structure attributes between home and host countries.

Examples include areas where:

Competition is less intense

Products are in different stages of their life cycle

Market demand is unsaturated

There are differences in market sophistication

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 6-21

Increasing Return from Ownership Advantages

. Ownership Advantages come from the application of

proprietary tangible and intangible assets in the host country.
 Reputation, brand image, distribution channels

 Technological expertise, organizational skills, experience

Core competence – skills within the firm that competitors

cannot easily imitate or match

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 6-22

Ensuring Growth from Organizational Learning

MNEs exposed to multiple stimuli, developing:
 Diversity capabilities
 Broader learning opportunities
Exposed to:
 New markets

 New practices

 New ideas

 New cultures

 New competition

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 6-23

The Impact of FDI on the Host Country

Employment
 Firms attempt to capitalize on abundant and inexpensive labor.

 Host countries seek to have firms develop labor skills and

sophistication.
 Host countries often feel like “least desirable” jobs are
transplanted from home countries.
 Home countries often face the loss of employment as jobs
move.

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 6-24

The Impact of FDI on the Host Country

FDI Impact on Domestic Enterprises

 Foreign invested companies are likely more productive than
local competitors.
 The result is uneven competition in the short run, and
competency building efforts in the longer term.
 It is likely that FDI developed enterprises will gradually
develop local supporting industries, supplier relationships in
the host country.

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 6-25

Product Life-Cycle Theory

Ray Vernon asserted that product moves to lower income

countries as products move through their product life cycle.

The FDI impact is similar: FDI flows to developed countries for

innovation, and from developed countries as products evolve
from being innovative to being mass-produced.

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 6-26

Monopolistic Advantage Theory

An MNE has and/or creates monopolistic advantages that

enable it to operate subsidiaries abroad more profitably than
local competitors.

Monopolistic Advantage comes from:

Superior knowledge – production technologies, managerial
skills, industrial organization, knowledge of product.
Economies of scale – through horizontal or vertical FDI

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 6-27

Internationalization Theory
When external markets for supplies, production, or distribution
fails to provide efficiency, companies can invest FDI to create
their own supply, production, or distribution streams.
Advantages
Avoid search and negotiating costs
Avoid costs of moral hazard (hidden detrimental action by
external partners)
Avoid cost of violated contracts and litigation
Capture economies of interdependent activities
Avoid government intervention
Control supplies
Control market outlets
Better apply cross-subsidization, predatory pricing and
transfer pricing
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 6-28

The Eclectic Paradigm

OLI Framework
O – Ownership-specific
Tangible assets, such natural endowments, manpower, and
capital.
Intangible assets, such as technology and information,
managerial, marketing and entrepreneurial skills.
L – Location-specific
Market structure, government policies, and political, legal,
and cultural environment.
I – Internationalization
Firm’s inherent flexibility and capacity to produce and
market through its internal subsidiaries.
All three factors important in determining the extent and pattern
of FDI.
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 6-29

The Eclectic Paradigm

Distinguishes between:

Structural market failure – external condition that gives

rise to monopoly advantages as a result of entry barriers

Transactional market failure – failure of intermediate

product markets to transact goods and services at a lower
cost than internationalization

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 6-30

The Dynamic Capability Perspective

A firm’s ability to diffuse, deploy, utilize and rebuild firm-

specific resources for a competitive advantage.

Ownership specific resources or knowledge are necessary but not

sufficient for international investment or production success.

It is necessary to effectively use and build dynamic capabilities

for quantity and/or quality based deployment that is transferable
to the multinational environment.

Firms develop centers of excellence to concentrate core

competencies to the host environment.

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 6-31

The Evolutionary Perspective

International investment is an ongoing, evolutionary process
shaped by an MNE’s:
International experience
Organizational capabilities
Strategic objectives
Environmental dynamics
Also known as the Uppsala model.
Distinguishes two kinds of knowledge:
Objective – can be taught
Experiential – can be acquired through personal experience

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 6-32

The Evolutionary Perspective

Firms progressively engage in a target market:
 Export takes place via independent representatives

 Sales subsidiaries are set up, specializing in marketing and

promotion
 Manufacturing facilities are established

 Insideration – MNEs shift major functions to local subsidiaries

 Complete globalization – MNEs coordinate common functions;

foreign subsidiaries share common purposes and corporate
mission

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 6-33

The Evolutionary Perspective

Another pattern is that firms entering new markets involve

greater psychic distance:

Differences in language, culture, political systems that

disturb the flow of information between firm and market

Familiarity theory – firms would rather invest in host

countries that are relatively close to it culturally

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 6-34

The Integration-Responsiveness Perspective

FDI is a complex process requiring coordinating subsidiary

activities across national boundaries.

Global integration – the coordination of activities across

countries to build efficient operations networks

Local responsiveness – response to specific host country

needs.

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 6-35

The Integration-Responsiveness Perspective

Advantages of Strategic Flexibility:

 Production movement

 Tax avoidance

 Financial arbitrage

 Information transfer

 Competitive power

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 6-36

Patterns of FDI

FDI continues to register dramatic growth:

1980 – global FDI stock was 10% of global GDP

1999 – global FDI stock was 31% of global GDP

Composition of FDI continues to change:

Increase in financial services, tourism, retail operations,

healthcare

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 6-37

Patterns of FDI
Exhibit 3-2: Growth of sales and gross product associated with
international production, GDP and exports, 1982 -1999

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 6-38

Patterns of FDI
Exhibit 3-3: Selected indicators of FDI and international
production, 1982-2000

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 6-39

FDI Outflows

Developing countries account for most of the FDI outflow.

Developed countries are more likely to:

Possess ownership or monopolistic advantages

Be innovators

Extract advantages from internalization

Have the dynamic capabilities for successful ventures

abroad

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 6-40

FDI Outflows
Exhibit 3-4: Outward FDI Stock, 1985

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 6-41

FDI Outflows
Exhibit 3-4: Outward FDI Stock, 2000

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 6-42

FDI Outflows

Exhibit 3-5: Developed

countries: FDI outflows, 1999
and 2000

Note that the U.S. places

third behind the UK and
France
U.S. remains first in
terms of FDI outward
stock

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 6-43

FDI Inflows

Significant growth in overall FDI Inflows

In the 1998 – 2000 period:

59% of incoming stock went to developed economies

75% of inflow went to developed countries

Significant increases in:

Latin America

South, East, and Southeast Asia

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 6-44

FDI Inflows
Exhibit 3-6: Inward FDI Stock, 1985

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 6-45

FDI Inflows
Exhibit 3-6: Inward FDI Stock, 2000

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 6-46

FDI Inflows
Exhibit 3-7: Share of developing countries in world FDI, 1980-2000
Note that the curves for inflows and outflows track each other.

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 6-47

Inflows into Developing Countries

What explains the declining share of FDI inflows in developing
economies:
Growing share of services in developed economies makes
them ripe for investment services.
Decline in value of labor and commodities in overall product
prices erodes competitive advantage.
Developed countries offer:
A stable environment
Low corruption
A large market
A skilled workforce

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 6-48

Inflows into Developing Countries

Exhibit 3-9: Share of the largest recipients of FDI flows among developing
economies, 1985-2000

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 6-49

FDI via Mergers and Acquisitions

Proportion of M&As growing at the expense of greenfield

investments.

From 52% in 1987 to 83% in 1999

Brings new technologies and better management that allow the

acquired firm to survive.

Most M&As originate in and target developed country firms.

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 6-50

Intra-Regional Patterns

In most host countries, the distribution of FDI is uneven

Four states in the U.S. had only ¼ of manufacturing

employment of Japanese affiliates

These same four states had 2/3 of their R&D facilities

Regional distribution of FDI is often correlated with the

investor country of origin

May be predicted by the theory of familiarity

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 6-51

Intra-Regional Patterns
Exhibit 3-11: Distribution of production of foreign affiliates in the U.S.,
by state (1992)

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 6-52

The Investment Environment

Liberalization of markets and openness to FDI on the increase.
In 1991-2000, 1,185 regulatory changes
1,121 favored investors
In 1999, 150 regulatory changes in 69 nations
147 positive to FDI
Many countries offer incentives, such as:
 Tax holidays
 Tariff concessions
 Direct and indirect financial subsidies
 Training support
 Infrastructure improvement
 Capital repatriation rights

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 6-53

FDI Decision Criteria

Natural and creative endowments vary by region and industry,

and tend to shift over time.

U.S. manufacturers are more likely to choose a high- rather than

a low-wage country for investment.

National boundaries not always a good indication of key criteria

for location decision.

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 6-54

Foreign Investment Location Criteria

Essential Criteria
 Access to skilled and educated workforce
 Proximity to world class research institutions
 Quality of life
 Access to venture capital
Important Criteria
 Reasonable costs of doing business
 Established technology presence
 Available bandwidth and adequate infrastructure
 Favorable business climate and regulatory environment
Desirable Criteria
 Presence of suppliers and partners
 Availability of community incentives

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 6-55

The Lost Continent: FDI in Africa

Africa draws only 1.2 percent of the share of global FDI.

UNCTAD report observes:

FDI in Africa has been on the increase

Per-capita income in Africa has been on the increase

Significant variations from country to country

New investors merging (Canada, Italy, the Netherlands,

Norway, and others)

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 6-56

The Lost Continent: FDI in Africa

UNCTAD report observes:

 Inward FDI originating in other African countries is taking
place
 FDI in Africa has expanded from mining and energy into
manufacturing and services
 FDI in Africa has proven profitable; more profitable than in
other developing economies

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 The Form of FDI: Acquisitions versus Greed- 6-57
Fields
The majority of investments
is in the form of mergers &
acquisitions:
Represents about 77% of
all flows in developed
countries.
Represent about 33% of
all flows in developing
countries.
Fewer target firms.
Why the preference for
mergers & acquisitions?
Quicker to execute.
Foreign firms have
valuable strategic assets.
Believe they can increase
the efficiency of the
acquired firm.

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 6-58

FDI and Risk

FDI is expensive and risky compared to exporting or
licensing:
Costs of establishing facilities.
Problems with doing business in a different
Culture.
Horizontal Direct Investment: FDI in the same industry as
the firm operates at home.
Factors to consider:
Transportation Costs.
Market Imperfections.
Following Competitors.
Strategic Competitors
Location Advantages.

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 6-59

Horizontal FDI and Factor Considerations

Transportation Costs: High/low value to weight impacts
costs.
Market Imperfections (Internalization Theory): Factors
that inhibit markets from working perfectly. This
includes (1) governments impeding the free flow of
products between nations, and (2) impediments to
the sale of know-how.
Strategic Behavior: Concentrated industries (oligopoly) tend
to mimic each other’s moves. Where there is
multipoint competition, competing firms match each
other’s moves to keep the competitor in check.

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 6-60

Horizontal FDI and Factor Considerations

The Product Life Cycle: Suggests that foreign market
demand leads to FDI, probably not true and
therefore is not a good predictor of FDI.

Location-Specific Advantages: Advantages that arise

from using resource endowments or assets tied
to a particular location (Dunning - eclectic paradigm)

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 6-61

Vertical FDI

Two forms:

Backward: Providing inputs (raw materials, parts) for a

firm’s domestic production processes.

Forward: An industry abroad sells the outputs of the firm’s

domestic production processes.

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 6-62

Why Do Companies Engage in FDI?

Strategic Behavior: Can raise entry barriers or shut out

new competitors, or circumvent barriers established by
companies already doing business in the foreign country.

Market Imperfections: Need to overcome lack of know-how

or the firm must invest in specialized assets whose value
depends on inputs provided by a foreign supplier.

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 6-63

Impediments to the Sale of Know-how

Risk giving away

know-how to
competitors

Impediments to Licensing implies

the sale of know low control over
how foreign entity

Know-how not
amenable to
licensing

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 6-64

A Decision Framework
Figure 6.6

How high are Low Export

transportation costs and
tariffs?
High
No
Is know-how amenable to Horizontal FDI
licensing?
Yes
Is tight control over foreign Yes
Horizontal FDI
operation required?

No
Can know-how be protected by
No
Horizontal FDI
licensing contract?
Yes
Then license
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 6-65

End of Chapter Five

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