International Business Final

Reasons for FDI Growing More Rapidly than World Trade and World Output

(1) Despite the general decline in trade barriers over the past 30 years, firms still fear protectionist pressures; (2) much of the increase in FDI has been driven by the political and economic changes that have been occurring in many of the world's developing nations; (3) the globalization of the world economy is also having a positive impact on the volume of FDI.

How FDI Helps a Country Achieve a Current Account Surplus

(1) If the FDI is a substitute for imports of goods or services, the effect can be to improve the current account of the host country's balance of payments. (2) A potential benefit arises when the MNE uses a foreign subsidiary to export goods and services to other countries.

Issues with Knickerbocker's Theory

(1) It does not explain why the first firm in an oligopoly decides to undertake FDI rather than to export or license. (2) It does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad.

Three Major Drawbacks of Licensing According to Internationalization Theory

(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 manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitability; (3) when a firm's competitive advantage is base not as much on its products as on the management, marketing, and manufacturing capabilities that produce those products, such capabilities are often not amenable to licensing.

Adverse Effects on the Balance of Payments

(1) Set against the initial capital inflow that comes with FDI must be the subsequent outflow of earnings from the foreign subsidiary to its parent company. (2) Another concern arises when a foreign subsidiary imports a substantial number of its inputs from abroad, which results in a debit on the current account of the host country's balance of payments.

Reasons for Retreat of the Radical Position

(1) The collapse of communism in Eastern Europe. (2) The generally abysmal economic performance of those countries that embraced the radical position, and a growing belief by many of these countries that FDI can be an important source of technology and jobs and can stimulate economic growth. (3) The strong economic performance of those developing countries that embraced capitalism rather than radical ideology.

Home Country Benefits of FDI

(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 when the foreign subsidiary creates demand for home-country exports. (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.

Home Country Costs of FDI

(1) The home country's balance of payments may suffer from the initial capital outflow required to finance the FDI, if the purpose of the foreign investment is to serve the home market from a low-cost production location, and if the FDI is a substitute for direct exports. (2) The most serious concerns arise when FDI is seen as a substitute for domestic production which reduces home-country employment.

Strategic Behavior Theory

Based on the idea the FDI flows are a reflection of strategic rivalry between firms in the global marketplace. An early variant of this argument was expounded by F.T. Knickerbocker, who looked at the relationship between FDI and rivalry in oligopolistic industries.

Greenfield Investment

A form of FDI which involves the establishment of a new operation in a foreign country.

Oligopoly

An industry composed of a limited number of large firms (e.g., and industry in which four firms control 80 percent of a domestic market would be defined as an oligopoly).

Eclectic Paradigm

Championed by British economist John Dunning. He argues that location-specific advantages are also of considerable importance in explaining both the rational for and the direction of foreign direct investment.

Employment Effects

FDI brings jobs to a host country that would otherwise not be created there. Direct effects arise when a foreign MNE employs a number of host-country citizens. Indirect effects arise when jobs are created in local suppliers as a result of the investment and when jobs are created because of increased local spending by employees of the MNE.

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 and thus boost that country's economic growth rate.

Balance-of-Payments Effects

FDI's effect on a country's balance-of-payments accounts is an important policy issue for most host governments.

Advantages of FDI

Firms will favor FDI over exporting when transportation costs or trade barriers make exporting unattractive, and firms will favor FDI over licensing 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.

Adverse Effects on Competition

Host governments sometimes worry that the subsidiaries of foreign MNEs may have greater economic power than indigenous competitors. If it is part of a larger international organization, the foreign MNE may be able to draw on funds generated elsewhere to subsidize its costs in the host market, which could drive indigenous companies out of business and allow the firm to monopolize the market.

Second Form of FDI

Involves acquiring or merging with an existing firm in a foreign country.

Licensing

Involves granting a foreign entity (the licensee) the right to produce and sell the firm's product in return for a royalty fee on every unit sold.

Exporting

Involves producing goods at home and then shipping them to the receiving country for sale.

Issues with Vernon's Product Life-Cycle Theory

It fails to explain why it is profitable for a firm to undertake FDI at such times rather than continuing to export from its home base or licensing a foreign firm to produce its product.

Externalities

Knowledge "spillovers" between a network of contacts that allows firms to benefit from each other's knowledge generation. A well-established theory suggest that firms can benefit from such externalities by locating close to their source.

Host Country Policies to Regulate FDI

Policies to encourage inward FDI include offering incentives to foreign firms to invest in their countries such as tax concessions, low-interest loans, and grants or subsidies. Policies to restrict inward FDI include ownership restraints such as exclusion from specific fields, and restricting amount of equity that can be invested, and performance requirements relating to local content, exports, technology transfer, and local participation in top management.

Home Country Policies to Regulate FDI

Policies to encourage outward FDI include foreign risk insurance, capital assistance, tax incentives, and political pressure. Policies to restrict outward FDI include limiting capital outflows out of concern for the country's balance of payments, manipulating tax rules to try to encourage firms to invest at home, and prohibiting national firms from investing in certain countries for political reasons.

Product Life-Cycle Theory

Raymond Vernon's theory is also used to explain FDI. He argued that often the same firms that pioneer a product in their home markets undertake FDI to produce a product for consumption in foreign markets.

Shifting Ideology Towards FDI

Recent years have seen a marked decline in the number of countries that adhere to a radical ideology. An increasing number of countries are gravitating toward the free market end of the spectrum and have liberalized their foreign investment regime.

Offshore Production

Refers to FDI undertaken to serve the home market.

National Sovereignty and Autonomy Effects

Some host governments worry that FDI is accompanied by some loss of economic independence. The concern is that 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.

Theories of FDI

Some theories seek to explain why a firm will favor direct investment as a means of entering a foreign market as opposed to other alternatives, some attempt to explain the observed pattern of foreign direct investment flows, and another, known as eclectic paradigm, attempts to combine the two other perspectives into a single holistic explanation of foreign direct investment.

Gross Fixed Capital Formation

Summarizes the total amount of capital invested in factories, stores, office buildings, and the like. Other things being equal, the greater the capital investment in an economy, the more favorable its future growth prospects.

World Trade Organization Involvement in FDI

The WTO has become involved in regulations governing FDI. Most of the WTO's efforts have been to push for the liberalization of regulations governing FDI, particularly in services. The WTO has not had much success in trying to initiate talks aimed at establishing a universal set of rules designed to promote the liberalization of FDI.

Location-Specific Advantages

The advantages that arise from utilizing 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 capabilities).

Inflows of FDI

The flow of FDI into a country.

Outflows of FDI

The flow of FDI out of a country.

Host Country Benefits of FDI

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.

Acquisitions Versus Greenfield Investments

The majority of cross-border investment is in the form of mergers and acquisitions rather than greenfield investments. The reasons for this include: (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.

Trends in FDI

The past 30 years have seen a marked increase in both the flow and stock of FDI in the world economy. Over the past 30 years, the flow of FDI has accelerated faster than the growth in world trade and world output.

Multipoint Competition

This arises when two or more enterprises encounter each other in different regional markets, national markets, or industries. 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.

Foreign Direct Investment (FDI)

This occurs when a firm invests directly in facilities to produce or market a product in a foreign country.

Flow of FDI

This refers to the amount of FDI undertaken over a given time period (normally a year).

Stock of FDI

This refers to the total accumulated value of foreign-owned assets at a given time.

Internationalization Theory

This theory seeks to explain why firms often prefer foreign direct investment over licensing as a strategy for entering foreign markets (this approach is also known as the market imperfections approach).

The Pragmatic Nationalism View Towards FDI

This view holds 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. According to this view, FDI should be allowed so long as the benefits outweigh the costs.

Host Country Costs of FDI

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.

The Radical View Towards FDI

Traces its roots to Marxist political and economic theory. Proponents argue that the multinational enterprise (MNE) is an instrument of imperialist domination. They see the MNE as a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries. According to the radical view, FDI by the MNEs of advanced capitalist nations keeps the less developed countries of the world relatively backward and dependent on advanced capitalist nations for investment, jobs, and technology.

The Free Market View Towards FDI

Traces its roots to classical economics and the international trade theories of Adam Smith and David Ricardo. This view argues that international production should be distributed among countries according to the theory of comparative advantage. It also argues that FDI is a benefit to both the source country and the host country.

Balance-of-Payment Accounts

Track both a country's payments to and its receipts from other countries.

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.

Effect on Competition and Economic Growth

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 prices and increasing the economic welfare of consumers.