Ch. 8 Foreign Direct Investment

Direction of FDI

-FDI into developing nations and transition economies of eastern Europe and the old Soviet Union have increased -most inflows of FDI have been targeted at developing economies in Southeast Asia -the growing importance of China as a recipient of FDI has driven much of the increase in FDI

The Source of FDI

-USA has been consistently largest source of FDI since WWII (others include UK, France, Germany, Netherlands and Japan) --all these countries accounted for 60% of all FDI outflows (1998-2014) -largely due to the fact they are developed nations with the largest economies and held an interest in trading

International Institutions and the Liberalization of FDI

-WTO helps regulate FDI and has pushed for the liberalization of regulations governing free trade (esp in services)

Location-specific Advantages

-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

Host Country Costs of FDI

-adverse effects on competition -adverse effects on balance-of-payments -possible effects on national sovereignty and autonomy

Oligopoly

-an industry composed of a limited number of large firms -an industry in which four firms control 80% of a domestic market

Radical View of FDI (political ideology)

-argue that the multinational enterprise (MNE) is an instrument of imperialist domination that keeps developing nations reliant on developed capitalist nations for technology, jobs, etc **FDI is ALL bad

Free Market View of FDI (political ideology)

-argues that international production should be distributed among countries according to the theory of comparative advantage -in this view, MNE's are an instrument for dispersing the production of goods and services to the most efficient locations around the world and thus increases the efficiency of the overall world economy -believes that the resources transfers to a new country brought on by FDI allow the host country to gain in those areas of transfer and stimulate their own economy **FDI is ALL good

Eclectic Paradigm

-argument that combining location-specific assets or resource endowments and the firms own unique assets often requires FDI -requires firms to establish production facilities where the foreign assets or resource endowments are located -*combines two other theoretical perspectives

Multipoint Competition

-arises when two or more enterprises encounter each other in different regional markets, national markets or industries -economic theory suggests firms will try to match the other's moves in different markets to keep each other in check

Home (Source) Country Costs of FDI

-balance-of-payments can suffer in 3 ways: --suffers from initial capital outflow to finance FDI --balance-of-payments suffers if purpose of FDI is to serve home market from low-cost production location --balance-of-payments suffers if FDI is a substitute for direct exports -can also cost jobs in home country if the purpose of FDI is to move to cheaper labor

Pragmatic Nationalism View of FDI (political ideology)

-believes that FDI has both benefits and costs and should be undertaken when the benefits outweigh the costs (ex. Japan) Benefits: -brings host country capital, skills, technology and jobs Costs: -profits from investment go abroad to domestic firm instead of to host country -countries adopting pragmatic stance pursue policies that maximize national benefit and minimize national cost

Employment Effects (Host Country Benefits)

-brings jobs to a host country that would otherwise not be created there -direct effects arise when an MNE employs a number of host country citizens -indirect effects occur 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

Limitations of Exporting

-constraints from transportation costs and trade barriers make it unprofitable to ship products once production costs are also factored in (true of low value-to-weight ratio products like cement) -high value-to-weight goods (computers, medical equipment, etc) have little impact on the attractiveness of exporting, licensing and FDI bc transportation costs are minimal

Arguments Against FDI

-expensive because firm must bear costs of establishing production facilities in a foreign country -risky because of problems associated with doing business in a different culture where rules may be different -greater probability that firm undertaking FDI for the first time will make costly mistakes due to ignorance **arguments FOR FDI can be made by explaining limitations of exporting and licensing

Advantages of FDI

-favor FDI over exporting when transportation costs or trade barriers make exporting unattractive -favor FDI over licensing when it wishes to maintain control over technological know-how or over its operations/business strategy or if the firm's capabilities are not able to be licensed well

FDI in Response to Trade Barriers

-firms sometimes undertake FDI as a response to actual or threatened trade barriers like import tariffs or quotas -tariffs on imported goods increase the cost of exporting relative to FDI and licensing (govts can control this) -by limiting imports through quotas governments also increase attractiveness of FDI and licensing

Host Country Policy Instruments Encouraging Inward FDI

-incentives for investing include tax concessions, low-interest loans and grants or subsidies (incentives are usually motivated by desire to gain resource transfer and employment effects)

International Trade Theory and FDI

-international trade theory tells us that home-country concerns about the negative economic effects of offshore production may be misplaced (not as bad as we think) -offshore production could actually stimulate home country economic growth by free home country resources to concentrate on activities it has a comparative advantage in

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 receiving country for sale

Home Country Policy Instruments for Restricting Outward FDI

-limit capital outflows out of concern for country's balance-of-payments -manipulation of tax rules to encourage firms to invest at home (typically to create jobs at home) -prohibit national firms from investing in certain countries fro political reasons (can be formal or informal)

Home Country Policy Instruments for Encouraging FDI

-many investor nations have government-backed insurance programs to cover major types of foreign investment risk -offer government loans to firms wishing to invest in developing countries -elimination of the double taxation of income earned in foreign investments -number of home countries use their political influence to persuade host countries to relax restrictions on FDI

Internalization Theory

-marketing imperfection approach to foreign direct investment that seeks to explain why firms prefer FDI over licensing -addresses issue of efficiency and why firms FIRST choose FDI

Host Country Policy Instruments Restricting Inward FDI

-most common controls are ownership restraints and performance requirements -*ownership restraints* can come in many forms: --excluding foreign companies from certain fields/industries --requiring a certain portion of foreign subsidiary be owned by local investors

Foreign Direct Investment (FDI)

-occurs when a firm invests directly in facilities to produce or market a good or service in a foreign country -in US, FDI occurs when a US citizen or organization takes an interest of 10% or more in a foreign business entity

Flow of FDI

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

Stock of FDI

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

Host Country Benefits of FDI

-resource-transfer effects -employment effects -balance-of-payment effects -effect on competition and economic growth

Adverse Effects on Balance-of-Payments (Host Country Costs)

-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 (these outflows show as capital outflows on balance-of-payments) -concern also arises when foreign subsidiary imports a substantial number of inputs from abroad which result in a debit on the host country's current account

Inflows of FDI

-the flow of foreign direct investment into a country

Outflows of FDI

-the flow of foreign direct investment out of a country

Imitative Theory (Strategic Behavior)

-theory based on idea that FDI flows are a reflection of strategic rivalry between firms in the global marketplace -interdependence of firms in and oligopoly leads to imitative behavior (when i drop price, you drop price) -can be expanded to embrace idea of multipoint competition -developed by F.T. Knickerbocker

Effect on Competition and Economic Growth (Host Country Benefits)

-when FDI is done in the form of a greenfield venture it establishes a new enterprise, increasing the number of players in a market and consumer choice -increased competition encourages firms to invest in plant, equipment and R&D as they struggle to gain competitive edge -this results in increased productivity growth and innovations and greater overall economic growth

Possible Effects on National Sovereignty and Autonomy (Host Country Costs)

-worry that FDI is accompanied with some loss of economic independence (concerned that key decisions that affect economy of host country are being made by foreign firm)

Adverse Effects on Competition (Host Country Costs)

-worry that subsidiaries of foreign MNE's may have greater economic power than indigenous competitors -foreign firms can draw from other subsidiaries to support costs in host country more that an indigenous firm is able to -this can drive out indigenous firms and allow the foreign firm to monopolize the market -an acquisition may have a more neutral effect on competition but multiple acquisitions could result in a monopoly as well

Externalities

knowledge spillovers that occur when companies in the same industry locate in the same area

Balance-of-Payments Effects (Host Country Benefits)

-*Balance-of-payments Accounts:* track both a host's country's payments to and its receipts from other countries -*Current Account:* tracks the export and import of goods and services (deficit occurs when imports exceed exports and surplus occurs when exports exceed imports....most countries prefer to have a surplus) -FDI can help countries to run a current account surplus in 2 ways: --FDI serves as a substitute for imports of goods or services --inward FDI by foreign multinationals has driven export-led economic growth in a number of developing and developed nations

Resource Transfer Effects (Host Country Benefit)

-FDI can supply host country with capital, technology and management resources otherwise not available -technology can stimulate economic development and comes in the form of process of product technology

Trends of FDI

-FDI has grown more rapidly than world trade and world output....this is because: --despite decline in trade barriers, firms still fear protectionist pressures --increase has been driven by the political and economic changes that have been occurring in many of the world's developing nations

The Form of FDI: Acquisitions vs. Greenfield Investments

2 Forms of FDI: -greenfield investments (establishing new operations in a country) -acquisition or merger (with an existing firm in foreign country) -UN estimates 40-80% of all FDI inflows were in the form of a merger or acquisition (note that mergers occur way less in developing nations than they do in developed nations) Why Acquisition over Greenfield? -mergers and acquisitions are faster to execute -acquired firms often have valuable assets (brand loyalty, customer relations, trademarks/patents, etc) -firms believe they can increase efficiency of acquired foreign unit by transferring capital, technology or management skills

Theories of Foreign Direct Investment

3 Approaches: 1. explains why a firm favors FDI over exporting and licensing 2. explains why firms in the same industry tend to undertake FDI at the same time and why they favor certain locations over others for FDI 3. eclectic paradigm (combines other two perspectives)

Limitations of Licensing

3 Major Drawbacks (according to internalization theory): -licensing may 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 profits -if a firms competitive advantage comes from its management, marketing or manufacturing abilities, licensing is not good because these capabilities are not amenable to licensing (ex. Toyota)

Home (Source) Country Benefits of FDI

Benefits arise from 3 Sources: 1. home country's balance-of-payments benefit from inward flow of foreign earnings 2. employment effects arise when the foreign subsidiary creates a demand for home-country exports (importing parts from home country to fill demand needs in foreign country creates jobs) 3. MNE learns valuable skills from exposure to foreign markets that can be transferred back to home country