Foreign Direct Investment

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Lecture 10

• Foreign Direct Investment

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Outline

• Introduction
• Trends in FDI Slumping FDI
• Acquisition / Merging and Green-field Investment
• Forms of FDI
• Why there would be Horizontal FDI and Factor
  Considerations
• Why there would be Vertical FDI and Factor
  Considerations
• Decision Framework of FDI

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Outline

• H. Benefits and Costs of FDI to host country
• and home country
• I. Government Incentives and Disincentives for
  FDI
• J. Managerial Implications

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A. Introduction

• Foreign Direct Investment (FDI) occurs
• when a firm invests directly in facilities to
  produce and/or market a product in a foreign
  country
• Examples The Globalization of Toyota (Global
  Business Today P. 232-234)
• Ford and General Motors in Russia (Global
  Business Today P.267-268)
• 2 Types of FDI

Green-field investment A wholly new operation
in a foreign country
Company acquiring or merging with a firm in a
different country
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A. Introduction

• Why is FDI important?
• Firms want a presence in foreign markets
• Firms want control over growth of these foreign
  markets

To determine locations, advertising and other
related strategic decisions in the firms
interest
To gain first mover advantages
To ward off competitors
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B. Trends in FDI

• Marked increase in both the flow stock of FDI
• While developed nations still account for the
  largest share of FDI, inflow into developing
  nations has increased
• China and India account for 45 of Asias FDI in
  2004
• Global investors ranked China No. 1 FDI
  destination, followed by US and India in 2004
• Refer to the article India and China Asias FDI
  Magnets
• Example Foreign Direct Investment in China
  (Global Business Today P.240-241)

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B. Slumping FDI

• General slowdown in the growth rate of the world
  economy
• Uncertainty arises from the September 11, 2001
  attack on the US
• The bursting of the stock market bubble in the
  US
• limits the ability of many companies to raise
  additional capital to finance aggressive FDI
  activity, particularly mergers and acquisitions
• There are many terrorist attacks happened in
  various countries
• Example England

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C. Acquisition / Merger

• Some companies acquire or merge with another firm
  because acquisition / merger can
• facilitate quick entry
• facilitate local financing
• protect local market know-how
• eliminate competitor and buying problems
• have strategic valuable assets
• increase the efficiency of the acquired firm
• Acquisition or merging is most prevalent in
  developed nations
• Examples
• Cemexs Foreign Acquisitions (Global Business
  Today P.243)
• FDI by Volvo in South Korea (Global Business
  Today P.255)

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C. Green-field Investment

• Some companies decide to make green-field
  investment in a foreign country because
• no competitors exist / competitors do not provide
  the products
• local financial incentives encourage FDI
• Green-field investment is most prevalent in
  developing nations

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D. Forms of FDI

• There are 2 forms of FDI. They are
• horizontal direct investment
• vertical direct investment
• Horizontal Direct Investment refers to
• the FDI in the same industry abroad like the
  company operates at home
• 2 types of Vertical Direct Investment

Backward Direct Investment
Forward Direct Investment
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D. Forms of FDI

• The investment into an industry that provides
  inputs into a firms domestic production
• Example British Petroleum extracts the petroleum
  from the ores

Backward Direct Investment

• The investment in an industry that utilizes the
  outputs from a firms domestic production
  (typically sales and distribution)
• Example Volkswagen acquired a large number of
  dealers when entering the US market

Forward Direct Investment
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E. Why there would be Horizontal FDI and Factor
Considerations

• Transportation costs are high
• Example Low value-to-weight ratio like cement
• Limitations of licensing (Internalization Theory)
  
• The theory seeks to explain why firms prefer
  foreign direct investment to licensing as a
  strategy for entering foreign markets. According
  to the theory, there are 3 major drawbacks of
  licensing
• .

Licensing is inappropriate when a firms
competitive advantage is based more on skills
and capabilities in production
Licensing implies low control over foreign
entity
Licensing results in firm giving away
proprietary technology
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E. Why there would be Horizontal FDI and Factor
Considerations

• Market Imperfections
• Impediments to the free flow of products between
  nations
• Example FDI by Japanese auto companies in the US
  in 1980s due to quotas
• The firms imitate each others FDI
  (Knickerbockers theory of FDI)
• Examples
• Toyota and Nissan imitated Honda by undertaking
  their own FDI in US and Europe
• Kodak and Fuji compete against each other around
  the world (i.e. multipoint competition)

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E. Why there would be Horizontal FDI and Factor
Considerations

• Product Life Cycle
• However, Product Life Cycle does not explain when
  it is profitable to invest abroad
• It may still be more profitable to produce at
  home and export to foreign countries
• It may be more profitable for the firm to license
  a foreign firm to produce its products for sale
  in foreign countries

• Firms invest in a advanced
• country when demand in that
• country is large enough to
• support local production
• Example Xerox set up
• production facilities in Japan

• The cost pressures become
• intense in home country
• The firms shift their production
• facilities to developing countries
• where labour costs are lower
• Example Xerox shifted
• production to Thailand

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E. Why there would be Horizontal FDI and Factor
Considerations

• Location specific advantages
• 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
• Example Low-cost labour in China and
  highly-skilled labour in Silicon Valley, oil and
  minerals in Russia and Saudi Arabia
• Eclectic Theory
• This theory ties together location-specific
  advantages, ownership advantages, and
  internalization advantages. Eclectic meaning
  deriving ideas from various sources.

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F. Why there would be Vertical FDI and Factor
Considerations

• Backward FDI will occur when
• a firm has knowledge and ability to extract raw
  materials in another country and there is no
  efficient producers in that country who can
  supply raw materials to the firm
• Example DeBeers has the knowledge and skills
  needed to extract diamond from its ores
• Forward FDI will occur when
• a firm must invest in specialized assets whose
  value depends on inputs provided by a foreign
  supplier
• Example The value of an investment in an
  aluminum refinery depends on the availability of
  the desired kind of bauxite ore

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G. Decision Framework of FDI
How high are transportation costs and tariffs?
Export
Low
High
No
Is know-how amenable to licensing?
Horizontal FDI
Yes
Is tight control over foreign operation required?
Horizontal FDI
Yes
No
Can know-how be protected by licensing contract?
Horizontal FDI
No
Yes
licensing
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H. Benefits of FDI to Host Country

• Resource-transfer effects
• Capital in RD
• Technology
• Management
• Employment effect
• Direct
• When a foreign MNE employs a number of
  host-country citizens
• Indirect
• When jobs are created in local suppliers
• When jobs are created because of increased local
  spending by employees of the MNE

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H. Benefits of FDI to Host Country

• Increases competition and spurs economic growth
• Increases number of players in a market
• Increases competition and stimulates capital
  investments
• Examples Plant, equipment, RD
• ? Product and process innovations
• ? Productivity ?
• ? Increase consumer choices, drive down prices
  and increase
• economic welfare of consumers
• ? Greater economic growth

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H. Benefits of FDI to Host Country

• Balance-of-Payments effects

Initial capital inflow when MNE establishes
business
MNE uses a foreign subsidiary to export to other
countries
FDI substitutes for imports of goods and
services -
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H. Costs of FDI to Host Country

• Drive out local competitors or prevent their
  development
• When a foreign investor acquires 2 or more firms
  in a host country, and subsequently merges them,
  the effects may be to
• reduce the level of competition in that market
• create monopoly power for foreign firm
• reduce consumer choice and raise prices
• Profits brought home hurts (debit) a hosts
  capital account (repatriate earnings)
• Parts imported for assembly hurt trade balance
• Loss of economic independence
• Shift of economic power from host country to home
  country

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H. Benefits of FDI to Home Country
Create a demand for exports
Improve balance of payments from inward flow of
foreign earnings
Increase knowledge from operating in a foreign
environment
Create jobs through export demand
Benefit the consumer through lower prices
Free up employees and resources for higher
value activities
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H. Costs of FDI to Home Country

• Negative effect on Balance of Payments
• Initial capital outflow
• However, this effect is usually more than offset
  by the subsequent inflow of foreign earnings
• MNE uses foreign subsidiary to sell back to home
  market
• MNE uses foreign subsidiary as a substitute for
  direct exports
• Potential loss of jobs

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I. Government Incentives for FDI

• Incentives used by the government to encourage
  FDI in home country
• Risk insurance covering the risks of
  expropriation, war losses, inability to transfer
  profits back home, etc.
• Special funds or banks to make loans in
  developing countries
• Elimination of double taxation
• Incentives used by the government to encourage
  FDI in host country
• Tax incentives
• Low interest loans
• Stable government and stable policies

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I. Government Disincentives for FDI

• Disincentives used by the government to
  discourage FDI in home country
• Limit capital outflows
• Example Exchange control regulations in Britain
  from early 60s till 1979
• Manipulate tax rules to encourage domestic
  investment
• Example The British advanced corporation tax
  system taxed British companies foreign earnings
  at a higher rate than their domestic earnings,
  creating an incentive for them to invest at home
• Restrictions on investing in certain countries
  for political reasons
• Example The formal U.S. rules prohibited U.S.
  firms from investing in countries such as Cuba
  and Iran, whose political ideology and actions
  are judged to be contrary to U.S. interest.

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I. Government Disincentives for FDI

• Disincentives used by the government to
  discourage FDI in host country

Ownership restraints

• Foreign companies are excluded
• from certain industries
• Examples Natural resources,
• National defense

• Controls over the behavior of
• the MNEs local subsidiary
• Examples Local content,
• Technology transfer,
• Local participation in
• top management

Performance requirements
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J. Managerial Implication

• Location-specific advantages argument explains
  the direction of FDI
• However, location-specific advantages argument
  does not explain why firms prefer FDI to
  licensing or to exporting
• A host governments attitude towards FDI should
  be an important variable in deciding about
• where to locate foreign production facilities
• where to make a foreign direct investment