Chapter 8: Foreign Direct Investment
When a country is importing more goods and services than it is exporting, it is incurring a(n)
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. Governments typically prefer to see a current account surplus rather than a deficit.
Government Policy üA firm's bargaining power with the host government is highest when §The host government places a high value on what the firm has to offer §When there are few comparable alternatives available §When the firm has a long time to negotiate
A host government's attitude toward FDI is important in decisions about where to locate foreign production facilities and where to make a foreign direct investment.
host country benefits üEffect 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 üIncreased competition leads to §Increased productivity growth §Product and process innovation Greater economic growth
FDI's impact on competition in domestic markets may be particularly important in the case of services, such as telecommunications, retailing, and many financial services, where exporting is often not an option because the service has to be produced where it is delivered
Host-Country Benefits üResource Transfer Effects §FDI can bring capital, technology, and management resources that would otherwise not be available üEmployment Effects §FDI can bring jobs that would otherwise not be created there §Opponents say not all "new jobs" represent net additions in employment
Foreign management 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.
Host-Country Policies continued üRestricting Inward 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
International Institutions and the Liberalization of FDI üUntil recently there has been no consistent involvement by multinational institutions in the governing of FDI üThe formation of the World Trade Organization in 1995 changed this §The WTO has had some success in establishing a universal set of rules to promote the liberalization of FDI
Host Country Costs continued üPossible Effects on 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
Home Country Benefits 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
International Trade Theory and FDI üHome country concerns about the negative economic effects of offshore production (FDI undertaken to serve the home market) may not be valid §FDI may actually stimulate economic growth by freeing home country resources to concentrate on activities where the home country has a comparative advantage Consumers may also benefit in the form of lower prices
Home-Country Policies üEncouraging Outward FDI §Have government-backed insurance programs to cover major types of foreign investment risk §Have special funds or banks that make governmental loans to firms investing in developing countries §Have eliminated double taxation of foreign income §Many host nations have relaxed restrictions on inbound FDI
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, as was the case when Cemex acquired RMC in Britain (see the Management Focus). 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
Host Country Costs continued üAdverse Effects on the Balance of Payments §There are two possible adverse effects of FDI on a host country's balance-of-payments 1.The capital outflows as foreign subsidiaries repatriate earnings to the parent country 2.There is a debit on the current account of the host country's balance of payments associated with imports of input products by the foreign subsidiary
Home-Country Policies continued üRestricting 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
Host-Country Policies üEncouraging Inward FDI §Governments offer incentives to foreign firms to invest in their countries ØGain from the resource-transfer and employment effects of FDI ØCapture FDI away from other potential host countries
FDI and Government Policy §The location-specific advantages argument associated with Dunning help explain the direction of FDI §However, internalization theory is needed to explain why firms prefer FDI to licensing or exporting üExporting is preferable to licensing and FDI as long as transportation costs and trade barriers are low
Licensing is unattractive when üThe firm's proprietary property cannot be properly protected by a licensing agreement üThe firm needs tight control over a foreign entity in order to maximize its market share and earnings in that country üThe firm's skills and capabilities are not amenable to licensing
Ideology toward FDI has ranged from a radical stance that is hostile to all FDI to the non-interventionist principle of free market economies üBetween these two extremes is an approach that might be called pragmatic nationalism
The Radical View MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries
Foreign direct investment (FDI): a firm invests directly in new facilities to produce or market in a foreign country üA firm engaged in FDI is a multinational enterprise
The flow of FDI - the amount of FDI undertaken over a given time period üOutflows of FDI are the flows of FDI out of a country üInflows of FDI are the flows of FDI into a country The stock of FDI - the total accumulated value of foreign-owned assets at a given time
The Free Market View üInternational production should be distributed among countries according to the theory of comparative advantage §Countries should specialize in the production of goods and services they can produce most efficiently §The MNE increases the overall efficiency of the world economy
The free market view traces its roots to classical economics and the trade theories of Adam Smith and David Ricardo.
üSince World War II, the U.S. has been the largest source country for FDI üOther important source countries: the United Kingdom, the Netherlands, France, Germany, and Japan üChinese firms have recently emerged as major foreign investors
The largest source countries - the United States, United Kingdom, Japan, France, Germany, and the Netherlands - also predominate in rankings of the world's largest multinationals.
üThe radical view has been in retreat §The collapse of communism in Eastern Europe §The poor economic performance of those countries that had embraced the policy §The strong economic performance of developing countries that had embraced capitalism
The radical view traces its roots to Marxist political and economic theory.
Historically, most FDI has been directed at the least developed nations of the world.
false, Historically, most FDI has been directed at the developed nations of the world as firms based in advanced countries invested in the others' markets. During the 1980s and 1990s, the United States was often the favorite target for FDI inflows.
A current account deficit is also known as a(n)
Trade deficit, the current account tracks the export and import of goods and services. 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.
The WTO embraces the promotion of international trade in services.
True, the WTO embraces the promotion of international trade in services. Because many services have to be produced where they are sold, exporting is not an option. Given this, the WTO has become involved in regulations governing FDI.
Which of the following are national accounts that track both payments to and receipts from other countries?
balance-of-payments FDI's effect on a country's balance-of-payments accounts is an important policy issue for most host governments. A country's balance-of-payments accounts track both its payments to and its receipts from other countries.
Which of the following refers to the amount of FDI undertaken over a given period (normally a year)?
flow The flow of FDI refers to the amount of FDI undertaken over a given time period (normally a year). We also talk of outflows of FDI, meaning the flow of FDI out of a country, and inflows of FDI, the flow of FDI into a country.
Which view argues that international production should be distributed among countries according to the theory of comparative advantage?
free market The free market view traces its roots to classical economics and the international trade theories of Adam Smith and David Ricardo and argues that international production should be distributed among countries according to the theory of comparative advantage. Countries should specialize in the production of those goods and services that they can produce most efficiently.
Host governments use a range of controls to restrict inward FDI. The two most common are
ownership restraints and performance requirements. The two most common types of control exercised by host governments to restrict FDI are: (1) ownership restraints, often in the form of excluding foreign firms from specific fields or limiting foreign ownership stake in local subsidiaries, and (2) performance requirements related to local content, exports, technology transfer, and local participation in top management.
The tendency to aggressively court FDI believed to be in the national interest of a country is an aspect of
pragmatic nationalism. one aspect of pragmatic nationalism is the tendency to aggressively court FDI believed to be in the national interest by, for example, offering subsidies to foreign MNEs in the form of tax breaks or grants. The countries of the European Union often seem to be competing with each other to attract U.S. and Japanese FDI by offering large tax breaks and subsidies.
Which of the following is one of the limitations of exporting that leads companies to prefer FDI over exporting?
presence or threat of trade barriers Some firms undertake foreign direct investment as a response to actual or threatened trade barriers such as import tariffs or quotas. The desire to reduce the threat that trade barriers might be imposed is enough to justify foreign direct investment as an alternative to exporting.
HOST COUNTRY BENEFITS Balance-of-Payments Effects §The balance-of-payments account records a country's payments to and receipts from other countries §The current account records a country's export and import of goods and services
§A surplus is usually favored over a deficit §FDI can help achieve a current account surplus §If it is a substitute for imports of goods and services §If the MNE uses a foreign subsidiary to export goods and services to other countries
üAdvantages of Foreign Direct Investment § FDI will be favored over exporting when §Transportation costs are high §Trade barriers are high
§FDI will be favored over licensing when §The firm wants control over its technological know-how §The firm wants control over its operations and business strategy §The firm's capabilities are not amenable to licensing
The main benefits of inward FDI for a host country arise from
the resource-transfer effect, the employment effect, and the balance-of-payments effect. 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.
Franchising is essentially the service-industry version of licensing, although it normally involves much longer-term commitments than licensing.
true, Franchising is essentially the service-industry version of licensing, although it normally involves much longer-term commitments than licensing. With franchising, the firm licenses its brand name to a foreign firm in return for a percentage of the franchisee's profits. The franchising contract specifies the conditions that the franchisee must fulfill if it is to use the franchisor's brand name.
Ownership restraints and performance requirements are the two most common ways in which host governments restrict FDI.
true, 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.
Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries.
true, Knickerbocker's theory can be extended to embrace the concept of multipoint competition. Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries. Economic theory 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. 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 competitive attacks in other markets.
The stock of foreign direct investment refers to the total accumulated value of foreign-owned assets at a given time.
true, The stock of foreign direct investment refers to the total accumulated value of foreign-owned assets at a given time.
Trends in FDI üBoth the flow and stock of FDI in the world economy have increased over the last 35 years üFDI has grown more rapidly than world trade and world output
§Firms still fear protectionist policies §The shift toward democratic political institutions and free market economies encourages FDI §Globalization is prompting firms to ensure they have a significant presence in many regions of the world
üDunning's eclectic paradigm - in addition to the various factors discussed earlier, two additional factors must be considered when explaining both the rationale for and the direction of foreign direct investment
§Location-specific advantages - arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets §Externalities - knowledge spillovers that occur when companies in the same industry locate in the same area
Host Country Costs üAdverse 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
The Form of FDI: Acquisitions versus Greenfield Investments üGreenfield investments involve establishing new operation in a foreign country üAcquisitions 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
üStrategic Behavior §Knickerbocker explored the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms) §FDI flows reflect strategic rivalry between firms
§This theory can be extended to multipoint competition (when two or more enterprises encounter each other in different regional markets, national markets, or industries)
Home Country Costs üThe 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
üEmployment effects of outward FDI §If the home country is suffering from unemployment, there may be concern about the export of jobs
Three complementary perspectives üWhy does a firm favor direct investment over exporting and licensing? üWhy do firms in same industry undertake foreign direct investment at the same time and favor certain locations as targets for FDI? üEclectic paradigm combines these two perspectives
üExporting: producing goods at home and then shipping them to the receiving country for sale üLicensing: 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
Pragmatic Nationalism üFDI has benefits and costs §Benefits: inflows of capital, technology, skills and jobs §Costs: repatriation of profits to the home country and a negative balance of payments effect üFDI should be allowed only if the benefits outweigh the costs
üIn recent years, there has been a strong shift toward the free market stance §A surge in the volume of FDI worldwide §An increase in the volume of FDI directed at countries that have recently liberalized their regimes ØChina, India, Vietnam §But, some countries are becoming more hostile to FDI Venezuela, Bolivia
üLimitations of Exporting §An exporting strategy can be limited by transportation costs and trade barriers §When transportation costs are high, exporting can be unprofitable §Low value-to-weight ratio §Foreign direct investment may be a response to actual or threatened trade barriers such as import tariffs or quotas
üLimitations of Licensing §Internalization theory (aka market imperfections) §Licensing could result in a firm's giving away valuable technological know-how to a potential foreign competitor §Licensing 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 §Licensing may be difficult if the firm's competitive advantage is not amenable to it
üHistorically, most FDI has been directed at the developed nations of the world §The United States is a favorite target as is the European Union
üMore recently, developing nations have been the recipients of FDI §South, East, and Southeast Asia, and particularly China have received significant inflows §Latin America is also emerging as an important region for FDI