INTB chapter 8 Foreign Direct Investment

---- are motivated by a desire to gain from the resource-transfer and employment effects of FDI

Incentives

Within this framework, the ---- is an instrument for dispersing the production of goods and services to the most efficient locations around the globe

MNE

The radical view traces its roots to

Marxist political and economic theory

They see the MNE as a tool for exploiting host countries to the exclusive benefit of their

capitalist-imperialist home countries

The main benefits of inward FDI for a host country arise from

resource-transfer effects, employment effects, balance-of-payments effects, and effects on competition and economic growth

Because FDI is more costly and more risky than licensing, other things being equal, the theories argue that ----- is preferable to FDI

licensing

During the 1980s and 1990s, the ----- was often the favorite target for FDI inflows

United States

The free market view argues that international production should be distributed among countries according to the theory of

comparative advantage

That is, it requires the firm to establish production facilities where those foreign assets or resource endowments are

located

An industry composed of a limited number of large firms

oligopoly

The only way in which a current account deficit can be supported in the long run is by

selling off assets to foreigners

When ----- costs are added to ----- costs, it becomes unprofitable to ship some products over a large distance

transportation production

However, the location-specific advantages argument does not explain ---- firms prefer FDI to licensing or to exporting

why

Given this, the WTO has become involved in regulations governing

FDI

Technology can take two forms, both of which are valuable. Technology can be incorporated in a production process (e.g., the technology for discovering, extracting, and refining oil), or it can be incorporated in a product (e.g., personal computers). However, many countries lack the research and development resources and skills required to develop their own indigenous product and process technology. This is particularly true in less developed nations. Such countries must rely on advanced industrialized nations for much of the technology required to stimulate economic growth, and ---- can provide it

FDI

So why do so many firms apparently prefer FDI over either exporting or licensing?

The answer can be found by examining the limitations of exporting and licensing as means for capitalizing on foreign market opportunities

1) mergers and acquisitions are quicker to execute than greenfield investments

This is an important consideration in the modern business world where markets evolve very rapidly. Many firms apparently believe that if they do not acquire a desirable target firm, then their global rivals will

A critical competitive feature of such industries is interdependence of the major players:

What one firm does can have an immediate impact on the major competitors, forcing a response in kind

Economic theory tells us that the efficient functioning of markets depends on an adequate level of ----- between producer

competition

The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidize ----- in other markets

competitive attacks

Historically, most FDI has been directed at the ----- of the world as firms based in advanced countries invested in the others' markets

developed nations

Because many services have to be produced where they are sold, ----- is not an option (e.g., one cannot export McDonald's hamburgers or consumer banking services)

exporting

The amount of foreign direct investment undertaken over a given time period (normally one year).

flow of FDI

When discussing foreign direct investment, it is important to distinguish between the

flow of FDI and the stock of FDI

Executives see FDI as a way of circumventing (see around)

future trade barriers

The ----- of the world economy is also having a positive effect on the volume of FDI

globalization

Adverse effects on the balance of payments

go back and read

First, the balance of payments suffers from the

initial capital outflow required to finance the FDI

Host countries adopt policies designed both to restrict and to encourage ----- FDI

inward

Both these agreements contained detailed clauses that require signatories to liberalize their regulations governing

inward FDI, essentially opening their markets to foreign telecommunications and financial services companies

Another beneficial employment effect claimed for FDI is that it brings ----- to a host country that would otherwise not be created there

jobs

The objective behind such policies is to create ---- at home rather than in other nations

jobs

Imperfections in the operation of the market mechanism

market imperfections (same approach as internalization theory)

Recognizing this, countries adopting a pragmatic stance pursue policies designed to ---- the national benefits and ---- the national costs

maximize minimize

In practice, many countries have adopted neither a radical policy nor a free market policy toward FDI but, instead, a policy that can best be described as

pragmatic nationalism

FDI has grown more ---- than world trade and world output for several reasons

rapidly

Possible effects on national sovereignty and autonomy

read in book

Under the auspices of the WTO, two extensive multinational agreements were reached in 1997 to liberalize trade in

telecommunications and financial services

The viability of exporting physical goods is often constrained by

transportation costs and trade barriers

The theories suggest that exporting is preferable to licensing and FDI so long as

transportation costs are minor and trade barriers are trivial

By the early 1990s, the radical position was in retreat. There seem to be three reasons for this:

(1) the collapse of communism in eastern Europe; (2) the generally abysmal economic performance of those countries that embraced the radical position, in addition to a growing belief by many of these countries that FDI can be an important source of technology and jobs and can stimulate economic growth; and (3) the strong economic performance of those developing countries that embraced capitalism rather than radical ideology (e.g., Singapore, Hong Kong, and Taiwan)

The benefits of FDI to the home (source) country arise from three sources:

1) the home country's balance of payments benefits from the inward flow of foreign earnings 2) benefits to the home country from outward FDI arise from employment effects 3) benefits arise when the home-country MNE learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home country

suggests that rather like chess players jockeying for advantage, firms will try to match each other's moves in different markets to try to hold each other in check

Economic theory

Clearly, by any measure, ---- is a very important phenomenon in the global economy

FDI

Dunning's theory, therefore, seems to be a useful addition to those outlined previously because it helps explain how location factors affect the direction of

FDI

From the early 1960s until 1979, for example, Britain had exchange-control regulations that limited the amount of capital a firm could take out of the country. Although the main intent of such policies was to improve the British balance of payments, an important secondary intent was to make it more difficult for British firms to undertake -----

FDI

The general shift toward democratic political institutions and free market economies has encouraged

FDI

This is the case, for example, with cement. Thus, Cemex, the large Mexican cement maker, has expanded internationally by pursuing----, rather than exporting.

FDI

As transportation costs or trade barriers increase, exporting becomes unprofitable, and the choice is between

FDI and licensing

Similarly, by limiting imports through quotas, governments increase the attractiveness of

FDI and licensing

The imitative theory also does not address the issue of whether

FDI is more efficient than exporting or licensing for expanding abroad

In a classic example, in the 1960s, RCA licensed its leading-edge color television technology to a number of Japanese companies, including Matsushita and Sony. At the time, RCA saw licensing as a way to earn a good return from its technological know-how in the Japanese market without the costs and risks associated with foreign direct investment. However, Matsushita and Sony quickly assimilated RCA's technology and used it to enter the U.S. market to compete directly against RCA. As a result, RCA was relegated to being a minor player in its home market, while Matsushita and Sony went on to have a much bigger market share.

First, licensing may result in a firm's giving away valuable technological know-how to a potential foreign competitor

occurs when a firm invests directly in facilities to produce or market a good or service in a foreign country.

Foreign direct investment (FDI)

------ skills acquired through FDI may also produce important benefits for the host country. Foreign managers trained in the latest management techniques can often help improve the efficiency of operations in the host country, whether those operations are acquired or greenfield developments. Beneficial spin-off effects may also arise when local personnel who are trained to occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help establish indigenous firms. Similar benefits may arise if the superior management skills of a foreign MNE stimulate local suppliers, distributors, and competitors to improve their own management skills.

Foreign management

Since World War II, the ----- has consistently been the largest source country for FDI

United States

In general, while FDI in the form of greenfield investments should increase competition, it is less clear that this is the case when the FDI takes the form of

acquisition of an established enterprise in the host nation

National accounts that track both payments to and receipts from foreigners (other countries)

balance-of-payments accounts

Against these benefits must be set the apparent costs of FDI for the home (source) country. The most important concerns center on the

balance-of-payments and employment effects of outward FDI

The pragmatic nationalist view is that FDI has

both benefits and costs

FDI can benefit a host country by bringing capital, skills, technology, and jobs, but those benefits come at a

cost

In the balance of payments, records transactions involving the export or import of goods and services

current account

For such products, the attractiveness of exporting ----, relative to either FDI or licensing

decreases

Governments normally are concerned when their country is running a ---- on the current account of their balance of payments

deficit

Third, the current account of the balance of payments suffers if the FDI is a substitute for

direct exports

First, the location-specific advantages argument associated with John Dunning does help explain the ---- of FDI

direction

With regard to employment effects, the most serious concerns arise when FDI is seen as a substitute for

domestic production

As a further incentive to encourage domestic firms to undertake FDI, many countries have eliminated

double taxation of foreign income (i.e., taxation of income in both the host country and the home country)

Argument that combining location-specific assets or resource endowments and the firm's own unique assets often requires FDI; it requires the firm to establish production facilities where those foreign assets or resource endowments are located

eclectic paradigm

Viewed this way, FDI by the MNE increases the overall ----of the world economy

efficiency

Again, internalization theory addresses the

efficiency issue

Countries should specialize in the production of those goods and services that they can produce most

efficiently

FDI is ----- because a firm must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign enterprise

expensive

By placing tariffs on imported goods, governments can increase the cost of ---- relative to foreign direct investment and licensing

exporting

Sale of products produced in one country to residents of another country; producing goods at home and then shipping them to the receiving country for sale

exporting

Evidence suggests that European, Japanese, South Korean, and Taiwanese computer and semiconductor firms are investing in the Silicon Valley region precisely because they wish to benefit from the ---- that arise there

externalities

In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part, it arises from a network of informal contacts that allows firms to benefit from each other's knowledge generation. Economists refer to such knowledge "spillovers" as

externalities

Knowledge spillovers

externalities

Therefore, he argues that combining location-specific assets or resource endowments with the firm's own unique capabilities often requires

foreign direct investment

One reason for wanting control over the operations of a foreign entity is that the firm might wish to take advantage of differences in factor costs across countries, producing only part of its final product in a given country, while importing other parts from where they can be produced at lower cost. Again, a licensee would be unlikely to accept such an arrangement because it would limit the licensee's autonomy. For reasons such as these, when tight control over a foreign entity is desirable,

foreign direct investment is preferable to licensing

Many investor nations now have government-backed insurance programs to cover major types of

foreign investment risk

Through their choice of policies, home countries can both encourage and restrict FDI by local firms. We look at policies designed to encourage outward FDI first. These include

foreign risk insurance, capital assistance, tax incentives, and political pressure

Although few countries have adopted a pure free market policy stance, an increasing number of countries are gravitating toward the

free market end of the spectrum and have liberalized their foreign investment regime

That is, licensing tends to be more common, and more profitable, in fragmented, low-technology industries in which -------- is not an option

globally dispersed manufacturing

In addition, several advanced countries also have special funds or banks that make ------to firms wishing to invest in developing countries

government loans

Radical writers argue that the multinational enterprise (MNE) is an instrument of

imperialist domination

A current account deficit, or trade deficit as it is often called, arises when a country is

importing more goods and services than it is exporting

Flow of foreign direct investment into a country

inflows of FDI

In this regard, from both an explanatory and a business perspective, perhaps the most useful theories are those that focus on the limitations of exporting and licensing—that is,

internalization theories

A branch of economic theory known as ------ seeks to explain why firms often prefer foreign direct investment over licensing as a strategy for entering foreign markets

internalization theory

Marketing imperfection approach to foreign direct investment

internalization theory

tells us that home-country concerns about the negative economic effects of offshore production may be misplaced

international trade theory

Finally, countries sometimes prohibit national firms from ---- in certain countries for political reasons

investing

The United States has been an attractive target for FDI because of its

large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI

Dunning accepts the argument of internalization theory that it is difficult for a firm to

license its own unique capabilities and know-how

Occurs when a firm (the licensor) licenses the right to produce its product, use its production processes, or use its brand name or trademark to another firm (the licensee). In return for giving the licensee these rights, the licensor collects a royalty fee on every unit the licensee sells

licensing

Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time. One policy has been to limit

limit capital outflows out of concern for the country's balance of payments

A host government's attitude toward FDI should be an important variable in decisions about where to

locate foreign production facilities and where to make a foreign direct investment

there is a well-established theory suggesting that firms can benefit from such externalities by

locating close to their source

This is particularly true of products that have a ------ ratio and that can be produced in almost any location

low value-to-weight

many firms now believe it is important to have production facilities close to their -----. This too creates pressure for greater FDI

major customers

Once a firm undertakes FDI, it becomes a

multinational enterprise

Arises when two or more enterprises encounter each other in different regional markets, national markets, or industries

multipoint competition

Knickerbocker's theory can be extended to embrace the concept of

multipoint competition

Because an acquisition does not result in a net increase in the number of players in a market, the effect on competition may be

neutral

Insofar as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and, perhaps, production facilities so they too can learn about and utilize valuable ----- before those based elsewhere, thereby giving them a competitive advantage in the global marketplace

new knowledge

FDI undertaken to serve the home market

offshore production

an industry in which four firms control 80 percent of a domestic market would be defined as an

oligopoly

Flow of foreign direct investment out of a country

outflows of FDI

According to this view, FDI should be allowed so long as the benefits ---- the costs

outweigh

Host governments use a wide range of controls to restrict FDI in one way or another. The two most common are

ownership restraints and performance requirements

Second, much of the increase in FDI has been driven by the

political and economic changes that have been occurring in man y of the world's developing nations

First, despite the general decline in trade barriers over the past 30 years, firms still fear

protectionist pressures

Recent years have seen a marked decline in the number of countries that adhere to a

radical ideology

When a foreign investor acquires two or more firms in a host country and subsequently merges them, the effect may be to

reduce the level of competition in that market, create monopoly power for the foreign firm, reduce consumer choice, and raise prices

As might be expected for an institution created to promote free trade, the thrust of the WTO's efforts has been to push for the liberalization of

regulations governing FDI, particularly in services

Last, and perhaps most significant, a number of investor countries (including the United States) have used their Page 231political influence to persuade host countries to

relax their restrictions on inbound FDI

The types of risks insurable through these programs include the

risks of expropriation (nationalization), war losses, and the inability to transfer profits back home

FDI is ----- because of the problems associated with doing business in a different culture where the rules of the game may be very different

risky

Second, the current account of the balance of payments suffers if the purpose of the foreign investment is to

serve the home market from a low-cost production location

Thus, the free market view argues that FDI is a benefit to both the

source country and the host country

The total accumulated value of foreign-owned assets at a given time

stock of FDI

One theory is based on the idea that FDI flows are a reflection of

strategic rivalry between firms in the global marketplace

Foreign direct investment can make a positive contribution to a host economy by

supplying capital, technology, and management resources that would otherwise not be available and thus boost that country's economic growth rate

Governments typically prefer to see a current account ------ rather than a deficit

surplus

In addition, countries have occasionally manipulated -----rules to try to encourage their firms to invest at home

tax

It is common for governments to offer incentives to foreign firms to invest in their countries. Such incentives take many forms, but the most common are

tax concessions, low-interest loans, and grants or subsidies

Research supports the view that multinational firms often transfer significant ------when they invest in a foreign country

technology

Although Knickerbocker's theory and its extensions can help explain imitative FDI behavior by firms in oligopolistic industries, it does not explain why

the first firm in an oligopoly decides to undertake FDI rather than to export or license

These Page 233theories are useful because they identify with some precision how the

the relative profitability of foreign direct investment, exporting, and licensing varies with circumstances

Transportation costs aside, some firms undertake foreign direct investment as a response to actual or threatened ----- such as import tariffs or quotas

trade barriers

It follows that a firm will favor foreign direct investment over exporting as an entry strategy when ------- make exporting unattractive

transportation costs or trade barriers

Thus, the interdependence between firms in an oligopoly leads to -----; rivals often quickly imitate what a firm does in an oligopoly

imitative behavior

Although licensing may work, it is not an attractive option when one or more of the following conditions exist:

(1) the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) a firm's skills and capabilities are not amenable to licensing

Summary: All of this suggests that when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing:

(1) when the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) when the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) when a firm's skills and know-how are not amenable to licensing

According to internalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities:

1) licensing may result in a firm's giving away valuable technological know-how to a potential foreign competitor 2) Licensing does not give a firm the tight control over production, marketing, and strategy in a foreign country that may be required to maximize its profitability 3) such capabilities are often not amenable to licensing. While a foreign licensee may be able to physically reproduce the firm's product under license, it often may not be able to do so as efficiently as the firm could itself

Across much of Asia, eastern Europe, and Latin America, ----, -----, ----- programs that are open to foreign investors, and removal of many restrictions on FDI have made these countries more attractive to foreign multinationals

-economic growth -economic deregulation privatization

For example, the wave of FDI by Japanese auto companies in the United States that started in the mid 1980s and continues to this day has been partly driven by protectionist threats from Congress and by tariffs on the importation of Japanese vehicles, particularly light trucks (SUVs), which still face a 25 percent import tariff into the United States. For Japanese auto companies, these factors decreased the profitability of ----- and increased that of -----

-exporting -foreign direct investment

More generally, gaining technology, productive assets, market share, brand equity, distribution systems, and the like through FDI by purchasing the assets of an established company can all speed up -----,-------, and ----------.

-market entry -Improve production in the firm's home base -facilitate the transfer of technology from the acquired company to the acquiring company

When contemplating FDI, when do firms prefer to acquire existing assets rather than undertake greenfield investments?

1) mergers and acquisitions are quicker to execute than greenfield investments 2) foreign firms are acquired because those firms have valuable strategic assets, such as brand loyalty, customer relationships, trademarks or patents, distribution systems, production systems, and the like 3) firms make acquisitions because they believe they can increase the efficiency of the acquired unit by transferring capital, technology, or management skills

what are the three theories of FDI explain:

1) why a firm will favor direct investment as a means of entering a foreign market when two other alternatives, exporting and licensing, are open to it 2) why firms in the same industry often undertake foreign direct investment at the same time and why they favor certain locations over others as targets for foreign direct investment 3) the eclectic paradigm, attempts to combine the two other perspectives into a single holistic explanation of foreign direct investment (this theoretical perspective is eclectic because the best aspects of other theories are taken and combined into a single explanation)

Firms for which licensing is not a good option tend to be clustered in three types of industries:

1.) High-technology industries in which protecting firm-specific expertise is of paramount importance and licensing is hazardous. 2.) Global oligopolies, in which competitive interdependence requires that multinational firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors. 3.) Industries in which intense cost pressures require that multinational firms maintain tight control over foreign operations (so that they can disperse production to locations around the globe where factor costs are most favorable in order to minimize costs and maximize value).

To a large degree, the outcome of any negotiated agreement depends on the relative bargaining power of both parties. Each side's bargaining power depends on three factors:

1.) The value each side places on what the other has to offer. 2.) The number of comparable alternatives available to each side. 3.) Each party's time horizon.

According to the U.S. Department of Commerce, FDI occurs whenever a U.S. citizen, organization, or affiliated group takes an interest of ---- percent or more in a foreign business entity

10

While a foreign licensee may be able to physically reproduce the firm's product under license, it often may not be able to do so as efficiently as the firm could itself. As a result, the licensee may not be able to fully exploit the profit potential inherent in a foreign market

3) A third problem with licensing arises when the firm's competitive advantage is based not as much on its products as on the management, marketing, and manufacturing capabilities that produce those products. The problem here is that such capabilities are often not amenable to licensing

With licensing, control over production (of a good or a service), marketing, and strategy are granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions. One reason for wanting control over the strategy of a foreign entity is that a firm might want its foreign subsidiary to price and market very aggressively as a way of keeping a foreign competitor in check. Unlike a wholly owned subsidiary, a licensee would probably not accept such an imposition because it would likely reduce the licensee's profit, or it might even cause the licensee to take a loss. Another reason for wanting control over the strategy of a foreign entity is to make sure that the entity does not damage the firm's brand. This was the primary reason fashion retailer Burberry recently terminated its licensing agreement in Japan and switched to a strategy of direct ownership of its own retail stores in the Japanese marke

A second problem is that licensing does not give a firm the tight control over production, marketing, and strategy in a foreign country that may be required to maximize its profitability.

2) foreign firms are acquired because those firms have valuable strategic assets, such as brand loyalty, customer relationships, trademarks or patents, distribution systems, production systems, and the like

It is easier and perhaps less risky for a firm to acquire those assets than to build them from the ground up through a greenfield investment

Establishing a new operation in a foreign country

greenfield investment

FDI takes two main forms:

greenfield investment and acquiring or merging with an existing firm in the foreign country

For products with a ----- ratio, however, transportation costs are normally a minor component of total landed cost (e.g., electronic components, personal computers, medical Page 219equipment, computer software, etc.) and have little impact on the relative attractiveness of exporting, licensing, and FDI

high value-to-weight

The British advanced corporation tax system taxed British companies' foreign earnings at a higher rate than their domestic earnings. This tax code created an incentive for British companies to invest at

home

They note, for example, that key technology is tightly controlled by the MNE and that important jobs in the foreign subsidiaries of MNEs go to ------- nationals rather than to citizens of the host country

home-country

Contrary to the radical view, the free market view stresses that such resource transfers benefit the ----- country and stimulate its economic growth

host

They argue that MNEs extract profits from the host country and take them to their home country, giving nothing of value to the ---- country in exchange

host

However, Dunning's theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semiconductor industry. Many of the world's major computer and semiconductor companies—such as Apple Computer, Hewlett-Packard, Oracle, Google, and Intel—are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs there. According to Dunning's arguments, knowledge being generated in Silicon Valley with regard to the design and manufacture of computers and semiconductors is available nowhere else in the world. To be sure, that knowledge is commercialized as it diffuses throughout the world, but the leading edge of knowledge generation in the computer and semiconductor industries is to be found in Silicon Valley. In Dunning's language, this means that Silicon Valley has a ----- in the generation of knowledge related to the computer and semiconductor industries

location-specific advantage

Advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm's technological, marketing, or management know-how

location-specific advantages

Dunning argues that in addition to the various factors discussed earlier, ------ are also of considerable importance in explaining both the rationale for and the direction of foreign direct investment

location-specific advantages

They are also motivated by a desire to capture FDI away from other

political host countries

Such programs are particularly useful in encouraging firms to undertake investments in

politically unstable countries

Three costs of FDI concern host countries. They arise from:

possible adverse effects on competition within the host nation, adverse effects on the balance of payments, and the perceived loss of national sovereignty and autonomy

Historically, political ideology toward FDI within a nation has ranged from a dogmatic radical stance that is hostile to all inward FDI at one extreme to an adherence to the noninterventionist principle of free market economics at the other. Between these two extremes is an approach that might be called

pragmatic nationalism (is essentially the view that FDI's benefits to a country must outweigh the costs)

To a greater or lesser degree, many governments can be considered ------- when it comes to FDI

pragmatic nationalists

When FDI takes the form of a greenfield investment, the result is to establish a new enterprise, increasing the number of players in a market and thus consumer choice. In turn, this can increase the level of competition in a national market, thereby driving down ---- and increasing the ----- of consumers

prices economic welfare

First, inward investment has increased competition and stimulated investment in the modernization of telephone networks around the world, leading to better ----. Second, the increased competition has resulted in -----

service lower prices

The WTO has had less success trying to initiate talks aimed at establishing a universal set of rules designed to promote the liberalization of

FDI

----- theory addresses this phenomenon

Internalization

Accordingly, their policy is shaped by a consideration of the costs and benefits of FDI. Here, we explore the benefits and costs of FDI, first from the perspective of a ---- (receiving) country and then from the perspective of the -----(source) country

host home

Furthermore, the firm will favor foreign direct investment over licensing (or franchising) when it wishes to

maintain control over its technological know-how, or over its operations and business strategy, or when the firm's capabilities are simply not amenable to licensing, as may often be the case

The WTO embraces the promotion of international trade in

services