Foreign Direct Investment

Discussion Section February 16, 2007 Brian Chen

Agenda

Administrative

Index cards Starbucks FDI case due Word on section participation

Review Political Economy of FDI

Concepts/Definitions Application: Chinese Corporations Law relating to wholly foreign-owned enterprises (Time permitting) Concepts/Definitions

Foreign Direct Investment

Review

International Trade

Chicago school economists tend to favor free trade But there are political and economic grounds to governments to intervene to check absolute free trade These tools include:

Tariffs, subsidies, quotas, administrative policies, local content requirement, antidumping policies Both received government subsidies: One direct, one indirect, and the question is whether one form is worse than the other Also, there may be room to argue whether there are acceptable political and economic grounds for government intervention in these industries

Boeing v. Airbus

Chapter 8

The Political Economy of Foreign Direct Investment

Political Economy of FDI: Outline

Three Views

Radical View

Imperialist extraction of host country wealth Implication: Always bad for the host country Different countries have different comparative advantages; best to allow countries to engage activities for which they do so most efficiently Implication: Always good when countries are specializing in activities for which they have a comparative advantage Belief that FDI has costs and benefits, and whether to engage in FDI depends on whether the benefits exceed the cost What are the costs and benefits to the host country?

Free Market

Pragmatic Nationalism

Benefits Costs

FDI: Benefits to the Host Country

Resource Transfer Effects

Capital

MNE invests capital in foreign markets

Research supports that MNEs do transfer technology when they invest in a foreign country When MNEs invest and manage in a foreign country, they often transfer management skills to the host countrys workforce

Technology

Management

Employment Effects

MNEs, by investing in foreign countries, can create employment opportunities for the local workforce But: Acquisition vs. Greenfield Investment Balance of Payment: A countrys balance-of-payment is the difference between the payments to and receipts from other countries FDI can have beneficial and negative effects on a countrys balance of payment. We look at the beneficial effects next Efficient functioning of markets require adequate level of competition between producers

Balance of Payment Effects

Effect on Competition

FDI: Benefits to Host Countrys Balance of Payment

Initial Capital Inflow

When a company invests in a foreign country, it brings capital into that country
To the extent that the goods/services produced by the FDI substitute for imported goods/services, there is a positive effect on B-of-P

Substitute for Imports

Inflow of payments from export of goods and services

To the extent that the goods/services produced by the FDI are exported to another country, there is a positive effect on the host countrys B-of-P

FDI: Costs to Host Countries

Adverse Effects on Competition

MNEs may have too much power and kill off competition
After initial inflow of capital, subsequent outflow of capital from the earnings of the FDI FDI may import inputs from abroad

Adverse Effects on Balance of Payments

National Sovereignty and Autonomy

Key decisions that affect the host countrys economy may be made by a foreign parent that has no real commitment to the host country

FDI: Benefits & Costs to Home Country

Benefits

Stream of income from foreign earnings FDI may import intermediate goods or inputs for production from the home country, creating jobs MNEs may learn skills from exposure to foreign countries

Costs

Balance of payment:

Initial capital outflow (but often set off by future stream of foreign earnings) Current account suffers if FDI is to serve home market from lowcost production location Current account suffers if FDI is a substitute for direct export FDI a substitute for domestic production (e.g., Etch-A-Sketch)

Employment effects:

Government Policy Instruments and FDI: Host Country Policies

Encouraging Inward FDI

Tax concessions Low-interest loans Grants Subsidies

Restricting Inward FDI

Ownership restraints

Exclusion from certain industries Why do so?

To protect national interest (defense, etc) To facilitate resource-transfer

Performance requirements

Local content, exports, technology transfer, and local participation in top management

Government Policy Instruments and FDI: Home Country Policies

Encouraging Outward FDI

Insurance programs to cover major types of foreign investment risks Special funds or banks to make government loans Political influence to persuade host countries to relax restrictions on inbound FDI
Limit capital outflows Manipulate tax rules to encourage investment at home Outright prohibition from investing in certain countries

Restricting Outward FDI

Chinese Law on WOFC

What type of FDI did Starbucks engage in (in Thailand)?

Acquisition? Greenfield? Horizontal? Vertical? Wholly owned subsidiary? Joint Venture?

Suppose Starbucks invested in China instead, with the same facts. Does this law apply to your firm? What are the articles of law that protect the host country?

What are they trying to protect?

Why are they important to you? Does it subscribe to the Radical View, the Free Market View, or the National Pragmatism View? Why do you say so?

What are the article of law that protect the foreign investor?

How would you judge Chinas WOFC law?

Chapter 7

Foreign Direct Investment

FDI: Definition

What is FDI?

FDI occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country Examples:

Motorola sets up a plant in China to manufacture cell phones Starbuck purchases an existing UK firm, British Coffee, to sell coffee, tea and desserts in the UK Volkswagen and two Chinese joint venture partners Shanghai Automotive Industry Corporation (SAIC) and First Automotive Works (FAW) open their newly built gearbox plant in Shanghai "Volkswagen Transmission (Shanghai) Co. Ltd"

Alternatives to FDI

Licensing; Direct Export

FDI: Forms

Forms of FDI

Acquisitions

Purchase an existing company in the foreign country Set up a new company from the ground up in the foreign country Motorola investments money in China and builds a new plant to produce cell phones Starbucks purchases an existing UK firm British Coffee and sells coffee/tea/desserts under the name Starbucks

Greenfield Investments

Examples:

FDI: Forms (II)

Forms of FDI (II)

Wholly Owned Subsidiary

Occurs when the company in the foreign country is entirely controlled/owned by one single company.

Motorolas company that manufactures cell phones in China Starbucks acquisition that sells coffee/tea/desserts in the UK

Joint Ventures

Occurs when two or more companies together form a new company in the host country In the international context, usually occurs when one (or more) foreign company and one (or more) local company join to form a new company

Volkswagon + Shanghai Automotive Industry Corporation (SAIC) + First Automotive Works (FAW)

FDI: Horizontal vs. Vertical

Horizontal vs. Vertical Direct Investment

Horizontal

Investment in the same industry as a firm operates in at home

Examples: Starbucks and its international expansion MacDonalds and its international expansion

Vertical

Investment in a downstream supplier (backward) or upstream purchaser (forward) as compared to the business that the firm operates in its home country

Examples: Backward: Volkswagon + SAIC + FAW to produce gearbox (an input to Volkswagons home operation) Forward: Less common. Volkswagons acquisitions of dealers in the US (Volkswagon sold cars to the dealers in the US. I.e., Volkswagon sold the output of its home country operations to the US dealers that it acquired)

Why Horizontal FDI?

Transportation Costs Market Imperfections

Impediments to exporting Impediments to Sale of Know-How

Strategic Behavior Product Life Cycle Location Specific Advantages

Why Vertical FDI?

Strategic Behavior Market Imperfections

Impediments to Know-How Investment in Specialized Assets