Chapter Three

Foreign Direct investment(FDI)

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 Points should be covered
⚫ Meaning Of FDI
⚫ Forms of FDI
⚫ Direction, Trends and Source Of FDI
⚫ Theories of Forms of FDI
⚫ Cost Benefits of FDI
⚫ Strategies of FDI

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 Meaning Of FDI

Is a process where by residents of one country

(source country) acquire ownership of assets
for the purpose of controlling the production and
distribution and other activities.
The distinguishing feature of FDI in comparison
with other forms of international investments is
the element of control over the management
policy and decision. Razin(1999).

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 Meaning of FDI

 Foreign direct investment (FDI) occurs when a

firm invests directly in new facilities to produce
and/or market in a foreign country
 Once a firm undertakes FDI it becomes a
multinational enterprise
 There are two forms of FDI
1. A green field investment :- The establishment
of a wholly new operation in a foreign country
2. Acquisition or merging with an existing firm in
the foreign country

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 Forms of Direct investment
 It takes broadly three forms:
1.Green Field Investment
2.Merger and Acquisitions(M&A)
3.Brown Field Investment.

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 1.Green Field Investment.
 It is done through opening branches in host countries or
through making investment in the equity capital of the
host country firm.(Financial collaboration)
 If the parent hosts the entire equity of the host country
firm, the late is called wholly owned subsidiary of the
of the parent.
 If it is more than half, it is known as subsidiary.
otherwise, it is simply an affiliate.

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 Advantage of Green field investment

When we want to gain local government-related

benefits ( Subsidies, tax breaks etc)
o It requires a detailed analysis of the investment’s costs and
expected return
o It can be important to use analysis of similar companies or
business models in the target market to obtain a framework
for costs.

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 Dis-Advantage of Green field investment

It have slightly higher risks than an acquisition

because the costs may be unknown.
It slightly more flexibility to adjust costs according
to the parent company’s business plans
o A parent company would need to obtain costs for
land, building licenses, building construction,
maintenance of new facilities, labor, financing
approvals, and more

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2.Merger and Acquisition(M&A)
A merger occurs when two separate entities combine
forces to create a new, joint organization.
 For the case of, Amalgamation, both loose their
existence in the favor of a new company.
An acquisition refers to the takeover of one entity by
another.
For the case of aquision, the acquiring company
maintains its existence and the target company looses
its existence.
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 Con…

 Merger and Acquisition are either Horizontal or

Vertical or Conglomerate.

 Horizontal acquisitions when two or more firms

engaged in similar activities combine.
 Vertical acquisition is when two firms involved in
different stages of production of a single final
product combine. eg Oil exploration with a
refining
 Conglomerate when two or more firms engaged in
non-similar activities combine.

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 Advantage of Merger & acquisition

Simplify a lot of the tedious details involved in entering a

new market (legal and others issues)
Keep current management team and most of the current
executive-level processes
Reduce time to market introduction and competition (large
market share)
Reduce cost of operation (licensing, registrations, training, 
supply chain, lower cost of labor, lower cost of service or brand
name, customer base, financing relationships, and financing
access.

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 Dis-Advantage of Merger & acquisition

 International regulatory approvals can be lengthy

 They can also ultimately result in a blocking of the entire
acquisition altogether or certain divesting requirements that
can be problematic for a deal.

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 3. Brown Field.

 Is a combination of Green field and M&A and then make

huge investment for replacing plant and machinery in
the target company.

 Most cross-border investment involves mergers and

acquisitions rather than greenfield investments
 Acquisitions are attractive because
they are quicker to execute than greenfield investments
It is easier and less risky for a firm to acquire desired
assets than build them from the ground up
Firms believe they can increase the efficiency of an
acquired unit by transferring capital, technology, or
management skills
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 Cont’d

When a developing country is the target for FDI

flows, mergers and acquisitions are much less
common, probably because there are fewer firms
to acquire or merge with in developing countries.

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 The Shift To Services

FDI is shifting away from extractive industries and

manufacturing, and towards services

The shift to services is being driven by:

 The general move in many developed countries
toward services
The fact that many services need to be produced
where they are consumed
A liberalization of policies governing FDI in services
The rise of Internet-based global telecommunications
networks
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 FDI in the World Economy

 There are two ways to look at FDI

1. The flow of FDI - the amount of FDI undertaken
over a given time period
2. The stock of FDI - the total accumulated value
of foreign-owned assets at a given time
 Outflows of FDI are the flows of FDI out of a
country
 Inflows of FDI are the flows of FDI into a country

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 Direction, Trends and Source Of FDI

Both the flow and stock of FDI in the world economy

have increased over the last 20 years
FDI has grown more rapidly than world trade and
world output because
Firms still fear the threat of protectionism
The general shift toward democratic political
institutions and free market economies has
encouraged FDI
The globalization of the world economy is
prompting firms to undertake FDI to ensure they
have a significant presence in many regions of the
world
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 Cont’d
 Historically, FDI has been directed in developed nation such as:
United states, Europe's, Asian and Latin Americans (emerging
economies)
 Specifically, developed nation such as united states and most of
Europe's has been the largest source country for FDI
o Both flows the flow and stock of FDI in the world economy has
been increased through time over a decades
o Over a decades FDI there has been a shift towards in services ( as
a result of, service not exportable and presence of technologies
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 Cont’d

Gross fixed capital formation : The total amount of

capital invested in factories, stores, office
buildings, and the like is called Gross fixed capital
formation
The greater the capital investment in an economy,
the more favorable its future prospects are likely to
be
FDI can be seen as an important source of capital
investment and a determinant of the future
growth rate of an economy

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 The Source Of FDI

Since World War II, the U.S. has been the largest
source country for FDI
Other important source countries - the United
Kingdom, the Netherlands, France, Germany, and
Japan
These countries also predominate in rankings of
the world’s largest multinationals
The six countries accounted for about 56
percent of all FDI outflows from 1998 to 2008.

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 Factors affecting FDI

Question: Why do firms prefer FDI to either exporting

(producing goods at home and then shipping them to
the receiving country for sale) or licensing (granting a
foreign entity the right to produce and sell the firm’s
product in return for a royalty fee on every unit that
the foreign entity sells)?
Answer:
To answer this question, we need to look at the
limitations of exporting and licensing, and the
advantages of FDI

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 Factors affecting FDI

1. Limitations of Exporting - an exporting strategy

can be limited by transportation costs and trade
barriers
When transportation costs are high, exporting
can be unprofitable
Foreign direct investment may be a response to
actual or threatened trade barriers such as
import tariffs or quotas

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 Factors affecting FDI
2. Limitations of Licensing - has three major drawbacks
 Internalization theory (also known as market
imperfections) suggests
1. It may result in a firm’s giving away valuable
technological know-how to a potential foreign
competitor
2. It does not give a firm the tight control over
manufacturing, marketing, and strategy in a
foreign country that may be required to maximize
its profitability
3. It may be difficult if the firm’s competitive
advantage is not amendable to licensing
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 Factors affecting FDI

3. Advantages of Foreign Direct Investment - a

firm will favor FDI over exporting when
transportation costs are high
trade barriers are high
A firm will favor FDI over licensing when
it wants control over its technological
know-how
it wants over its operations and business
strategy
The firm’s capabilities are not amenable to
licensing
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 THEORIES OF FDI
1. Capital abundance theory( Mac Dougall-Kemp
Hypothesis)
According to this theory, foreign direct investment is a
result of differences in capital abundance between
economies.
FDI moves from capital abundant economy to capital
scarce economy till the marginal production is equal in
both countries.
This leads to improvement in efficiency in utilization of
resources in which leads to ultimate increase in welfare .
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 Cont
2. Industrial Organization Theory.
According to this theory, technological superiority is the
main driving force for foreign direct investment rather
that capital abundance.
According to this theory, MNC with superior technology
moves to different countries to supply innovated
products making in turn ample gains .
Krugman (1989) points out that it was technological
advantage possessed by European countries which led to
massive investment in USA .
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 Cont
3. Currency Based Approaches
A firm moves from strong currency country to weak currency
country.
Aliber(1971) postulates that firms from strong currency
countries move out to weak currency countries.
Froot and Stain(1989)holds that, depreciation in real value of
currency of a country lowers the wealth of a domestic
residents visa avis the wealth of the foreign residents ,thus
being cheaper for foreign firms to acquire assets in such
countries.
Therefore, foreign direct investments will move from
countries with strong currencies to those with weak or
depreciating currencies. 7-27
 Cont
4. Location –Specific Theory.
Hood and Young(1979) stress on the location factor.
According to them, FDI moves to a countries with
abundant raw materials and cheap labor force.
Abundance of raw materials and cheap labor force are
the main factors for FDI.
Countries with cheap labor and abundant raw material
will tend to attract FDI.
Since real wage cost varies among countries, firms with
low- cost technology move to low wage countries.
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 Cont
5. Product Cycle Theory.
FDI takes place only when the product in question
achieve specific stage in its life cycle(Vernon 1966)
introduction , growth, maturity and decline stage.
At maturity stage, the demand for new product in
developed countries grow substantially and rival firms
begin to emerge producing similar products at lower price.
So in order to compete with rivals, innovators decide to
set up production in the host country so as to beat up the
cost of transportation and tariffs.

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 cont
6. Political –Economic Theories.
They concentrate on the political risks.
Political stability in the host country leads to
FDI(Fatehi-Sedah and Safizeha 1989).
Similarly, political instability in the home country
encourages FDI in other countries(Tallman 1988).

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 Benefits and Costs of FDI

Question: What are the benefits and costs of FDI?

Answer:
The benefits and costs of FDI must be explored
from the perspective of both the host (receiving)
country and the home (source) country

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 Host Country Benefits

 The main benefits of inward FDI for a host

country are
1. the resource transfer effect
2. the employment effect
3. the balance of payments effect
4. effects on competition and economic growth

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 Host Country Benefits

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
2. Employment Effects
FDI can bring jobs that would otherwise not be
created there

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 Host Country Benefits

3. Balance-of-Payments Effects
A country’s balance-of-payments account is a
record of a country’s payments to and receipts
from other countries
The current account is a record of a country’s
export and import of goods and services
 Governments typically prefer to see a current
account surplus than a deficit
FDI can help achieve a current account surplus
if the FDI is a substitute for imports of goods
and services
if the MNE uses a foreign subsidiary to export
goods and services to other countries
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 Host Country Benefits

4. Effect on Competition and Economic Growth

FDI in the form of greenfield investment
 increases the level of competition in a market
 drives down prices
 improves the welfare of consumers
Increased competition can lead to
 increased productivity growth
 product and process innovation
 greater economic growth
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 Host Country Costs

 There are three main costs of inward FDI

1. The possible adverse effects of FDI on
competition within the host nation
2. Adverse effects on the balance of payments
3. The perceived loss of national sovereignty and
autonomy

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 Host Country Costs

1. Adverse Effects on Competition

The subsidiaries of foreign MNEs may have greater
economic power than indigenous competitors
because they may be part of a larger international
organization
The MNE could draw on funds generated
elsewhere to subsidize costs in the local market
Doing so could allow the MNE to drive
indigenous competitors out of the market and
create a monopoly position

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 Host Country Costs

2. Adverse Effects on the Balance of Payments

 There are two possible adverse effects of FDI on a
host country’s balance-of-payments
1. With the initial capital inflows that come with
FDI must be the subsequent outflow of capital
as the foreign subsidiary repatriates earnings to
its parent country
2. When a foreign subsidiary imports a substantial
number of its inputs from abroad, there is a
debit on the current account of the host
country’s balance of payments 7-38
 Host Country Costs

3. National Sovereignty and Autonomy

FDI can mean some loss of economic
independence
key decisions that can affect the host country’s
economy will be made by a foreign parent that
has no real commitment to the host country,
and over which the host country’s government
has no real control

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 Home Country Benefits

 The benefits of FDI to the home country include

1. The effect on the capital account of the home
country’s balance of payments from the inward
flow of foreign earnings
2. The employment effects that arise from
outward FDI
3. The gains from learning valuable skills from
foreign markets that can subsequently be
transferred back to the home country

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 Home Country Costs

 The most important concerns for the home

country center around
1. The balance-of-payments
 The balance of payments suffers from the
initial capital outflow required to finance the
FDI
 The current account is negatively affected if
the purpose of the FDI is to serve the home
market from a low-cost production location
 The current account suffers if the FDI is a
substitute for direct exports
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 Home Country Costs

2. Employment effects of outward FDI

 If the home country is suffering from
unemployment, there may be concern
about the export of jobs

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 Strategy for FDI
Firm-Specific Strategy.
1. Product differentiation strategy
It means offering new kind of product or differentiated
product.
When product innovation fails to work, a firm may adopt
product differentiation strategy.
Sometimes a firm may adopt different brands for different
markets to make them suitable for local markets.
 For example, Uniliver’s low – leather fabric washing
product is marketed is market under five different
brands in Western Europe.

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 2. Cost –Economic Strategy.

This strategy is done through lowering cost by

moving the firm to the places where there are
cheap factors of production(eg. labour and raw
materials).
The cheapness of these factors of production
reduces the cost of production and maintains an
edge over other firms.

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 Cont…

3. Joint Venture With a Rival Firm.

Sometimes when a rival firm in a host country is so powerful
that it is not easy for MNC to compete, the later prefer to join
hands with the host country firm for a joint venture agreement
and the MNC is able to operate the host country market.
4. Investment Mode Strategy.
This strategy depends on the move of investment favored by
the host country.
It depends also on the political and economic environment of
the host country.
If the host government does not favor a particular mode, an
investing company can not adopt it even if it is the most
suitable.
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 Government Policy and FDI

 FDI can be regulated by both home and host

countries
 Governments can implement policies to
1. Encourage FDI
2. Discourage FDI

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 Home Country Policies

1. Encouraging Outward FDI

Many nations now have government-backed
insurance programs to cover major types of
foreign investment risk
Can encourage firms to undertake FDI in
politically unstable nations
Many countries have also eliminated double
taxation of foreign income
Many host nations have relaxed restrictions on
inbound FDI

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 Home Country Policies

2. Restricting Outward FDI

 Virtually all investor countries, including the
United States, have exercised some control over
outward FDI from time to time
Countries manipulate tax rules to make it more
favorable for firms to invest at home
Countries may restrict firms from investing in
certain nations for political reasons

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 Host Country Policies

1. Encouraging Inward FDI

Governments offer incentives to foreign firms to
invest in their countries
motivated by a desire to gain from the resource-
transfer and employment effects of FDI, and to
capture FDI away from other potential host
countries

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 Host Country Policies

2. Restricting Inward FDI

Ownership restraints and performance
requirements are used to restrict FDI
Ownership restraints-exclude foreign firms from
certain sectors on the grounds of national security
or competition
local owners can help to maximize the resource
transfer and employment benefits of FDI
Performance requirements - used to maximize the
benefits and minimize the costs of FDI for the host
country 7-50
End of chapter three

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 Question

 In which strategy we can assign our country Ethiopia?

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